Understanding LIBOR

Why are Economists Worrying About a Rising LIBOR?

In the midst of the largest financial crisis since The Great Depression, you are probably hearing a lot about LIBOR rising—which is a sign that the global credit markets are seizing up because banks are afraid to loan to each other because they don't know if the other banks they are loaning to are going to exist next week, let along be able to pay back those loans. But what on earth is LIBOR?

London Interbank Offered Rate (LIBOR)

The financial markets are full of acronyms, and one of my favorites is LIBOR. The acronym LIBOR stands for London InterBank Offered Rate. This is the average interest rate that banks charge when they make short-term unsecured loans to other banks.

Unlike the Federal Funds Rate or the Discount Rate, which are both set by the U.S. Federal Reserve, nobody "sets" the LIBOR rate. Instead, the British Bankers' Association (BBA) surveys 16 different major banks and asks them what rate they are charging other banks to borrow money. Once they have compiled the results, they take an approach similar to the judges who score Olympic diving take—they throw out the four high scores (or rates) and throw out the four low scores and then find the average of the remaining eight scores.

Imagine the BBA goes out, surveys its 16 banks and ends up with the following interest rates being charged by each bank:

- Bank #1 — 3.87%
- Bank #2 — 3.85%
- Bank #3 — 3.81%
- Bank #4 — 3.76%
- Bank #5 — 3.75%
- Bank #6 — 3.74%
- Bank #7 — 3.71%
- Bank #8 — 3.69%
- Bank #9 — 3.67%
- Bank #10 — 3.66%
- Bank #11 — 3.63%
- Bank #12 — 3.62%
- Bank #13 — 3.60%
- Bank #14 — 3.57%
- Bank #15 — 3.53%
- Bank #16 — 3.48%

In this case, the BBA would throw out the top four rates (Banks 1–4) and the bottom four rates (Banks 13–16) and then average the rates from the remaining banks (Banks 5–12) to come up with a LIBOR rate of 3.68 percent.

The BBA conducts these surveys and then calculates the LIBOR rate once a day at about 11 am London time.

What Does LIBOR Tell Us?

When LIBOR is rising, it tells us one of two things: 1) it tells us that interest rates in general are rising and thus LIBOR is also rising, and/or 2) it tells us that lending banks believe the banks they are lending to have a higher risk of defaulting on the loan so the lending bank has to charge a higher interest rate to offset this risk.

When LIBOR is falling, it tells us one of two things: 1) it tells us that interest rates in general are falling and thus LIBOR is also falling, and/or 2) it tells us that lending banks believe the banks they are lending to have a lower risk of defaulting on the loan so the lending bank does not have to charge a higher interest rate to offset this risk.