All my Money and Banking students understand the importance of LIBOR (London Interbank Offered Rate) to the economy. The vast majority of lending rates are determined by LIBOR, and central banks are trying to influence this key interest rate whenever they engage in monetary policy. LIBOR also plays an important role in many derivative contracts.
LIBOR is simply the rate that banks pay to borrow funds from other banks. Some banks have insufficient reserves to back their deposits, whilst others have excess reserves. These reserves are traded on the interbank market and the rate banks pay is LIBOR. LIBOR is ultimately what banks pay to get their funds, which is why it is so closely connected to the rate borrowers pay.
LIBOR is determined on a daily basis by the British Banking Association. They conduct a daily survey asking major banks what they would pay to borrow funds in a reasonable market just before 11am. The survey results are averaged to produce LIBOR. Click here for further details.
However, it seems that some banks have been engaged in shady practices regarding this process. Click here for the timeline. Banks stand accused of two things. First, there is a suggestion that derivative traders at some banks influenced their bank’s daily survey response so that they could make profitable trades based on this influence. Second, it appears that banks understated their interbank borrowing costs during the height of the financial crisis in 2008. This was either to make them appear healthier than they were or it was the result of political pressure, with politicians desirous to lower LIBOR and borrowing costs for businesses and consumers (click here for the Telegraph's coverage this issue).