LIBOR: Understanding the Benchmark Interest Rate
In the world of finance, LIBOR is an acronym that frequently appears. But what exactly does it stand for, and why is it so important? In this case study, we will delve into the details of LIBOR – the London Interbank Offered Rate – and explore its significance in financial markets.
1. What is LIBOR?
LIBOR serves as a benchmark interest rate that indicates the average interest rate at which major global banks can borrow from each other on an unsecured basis. It represents the cost of short-term borrowing for these institutions and serves as a reference point for various financial products such as mortgages, student loans, credit cards, and derivatives.
2. How is LIBOR calculated?
The British Bankers’ Association (BBA) used to oversee LIBOR until 2014 when responsibility was transferred to ICE Benchmark Administration (IBA). Each business day, a panel of leading banks submits their estimated borrowing costs across multiple currencies and maturities to IBA. The highest and lowest submissions are eliminated while the remaining rates are averaged to determine LIBOR.
3. Why is LIBOR significant?
LIBOR plays a vital role in determining interest rates for trillions of dollars worth of financial contracts worldwide. It affects not only individuals with mortgages or personal loans but also organizations looking to raise capital or manage risks through derivatives contracts linked to this benchmark rate.
4. Controversies surrounding LIBOR:
In recent years, there have been several controversies related to manipulation attempts by certain banks involved in submitting their estimates for calculating LIBOR. These scandals raised serious concerns about market integrity and led regulatory authorities globally to implement reforms aimed at strengthening oversight and enhancing transparency in determining benchmark rates like LIBOR.
5. Transitioning away from LIBOR:
Due to its shortcomings highlighted during these controversies, regulators have initiated efforts towards transitioning away from using LIB