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).
