LIBOR, or London Interbank Offered Rate, is the interest rate at which banks borrow from each other. It is the rate of interest the lending bank expects to receive. LIBID, or London Interbank Bid Rate, is the rate of interest a bank wishing to borrow is prepared to pay. Both rates are set daily by the British Bankers’ Association (BBA) in London. While LIBID has no significance outside the interbank market, LIBOR is used as a key reference rate for a variety of other rates, such as those for adjustable rate mortgages, and student and small business loans in a few countries.
How the Two Rates Are Set
Every day, a group of major world banks tell the BBA what rates they expect they will have to pay and be willing to pay on loans taken or given. After discarding the top four and bottom four figures, the BBA comes up with the two averages, which are then published at 11 a.m. London time (6 a.m. EST). The BBA lists on its website a panel of 26 participating banks, including Bank of America, Citibank, JP Morgan Chase and Barclays. The rates are calculated for 10 major currencies, with a limit of 16 banks in each currency panel.
Why the Difference?
At first glance, it might seem unusual that there are two rates, because in any lending/borrowing transaction, the same interest rate should be used by both the lender and the borrower. However, as Brian Cole explains in “Money Markets,” banks active in the London interbank market quote two different rates so that they can profit from taking deposits and re-lending them. By asking for more on what it wants to receive in interest, which is LIBOR, than for it wants to pay for borrowed funds, which is LIBID, a bank can expect to make a profit on lending or re-lending.
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LIMEAN in the Middle
Because there is a difference between LIBOR and LIBID, in their transactions banks often use another reference, which is LIMEAN. It is the average of LIBOR and LIBID, and as Investopedia points out, it is a reliable reference to the interest rate used by the interbank market. Usually, the difference between LIBOR and LIBID is one-eighth of 1 percent (12.5 basis points), with fluctuations over the course of a day.
How the Interbank Market Works
At the start of each day or after they receive orders from their customers, banks decide how much they need to borrow or how much they can lend. They then enter the market trying to get funds at the best available rate. Because their needs change constantly, they also change the rates they offer or are willing to accept--LIBID and LIBOR. As “Money Markets” explains, most of the activity takes place in the morning. After 11 a.m., banks start withdrawing from the market, having borrowed or lent what they wanted.
- London image by Ripa from Fotolia.com