What Is a LIBOR Loan?

If you have come across the term LIBOR before, you've encountered what is arguably a cornerstone of modern international finance today. The term LIBOR is an acronym for the London Interbank Offered Rate. This particular term is used to describe the interest rate that is established by major international banks as the de facto standard for interbank borrowing.

LIBOR changes on a daily basis, with the most current rates being published and distributed by the Intercontinental Exchange, or ICE. Understanding the significance of LIBOR and its relevance in the global economy is key for anyone with a serious interest in international finance.

As mentioned previously, LIBOR is the average rate of interest that is used by international banks when they loan money to one another. Keep in mind that this rate is completely exclusive from interest rates attached to retail borrowing. When the daily LIBOR rate is established, it is derived using current five currency values as a reference: the U.S. dollar, the Euro, the Swiss franc, the Japanese yen and the British pound.

LIBOR rates are intended to serve seven key maturity lengths, those being overnight, one week, one month, two months, three months, six months and 12 months. With that in mind, the total number of LIBOR rates published each day total to 35 (five currencies, each with seven maturity lengths). Generally speaking, the most popular LIBOR rate used for reference is the U.S. dollar three-month yield.

The introduction of LIBOR first occurred in the 1980s. As the popularity and demand for interest rate-driven banking products began to increase, it became necessary for banks to establish a cohesive and consistent framework for establishing interbank lending rates. In 1984, the British Banking Association, commonly referred to as the BBA, introduced interest settlement rates in an effort to normalize banking transactions. Over the next two years, the process was further refined and expanded, culminating in the debut of the BBA's LIBOR in 1986. Since then, LIBOR has grown and expanded to become the industry standard for major economic powerhouses around the world.

That being said, it is important to remember that LIBOR is constantly being redefined in tandem with changes to the global economy. For example, the 2008 financial crisis deeply impacted LIBOR, resulting in a substantial decrease in the number of currencies which LIBOR had been configured for. As such, it is important to remember that LIBOR is a reflection of economic sentiments rather than an influencer of the global economy. For LIBOR to function correctly, it is must act as an honest and accurate readout of current banking policy.

In order to calculate the daily LIBOR figures, ICE queries a number of major international banks in order to determine what their current interest rates for short-term loans to other banks are. Once all of the quotes have been collected, ICE removes the highest and lowest rates submitted and then creates an average of the remaining figures. Within the industry, this averaged figure is referred to as the "trimmed average."

Once this information has been gathered and the necessary calculations completed, the daily LIBOR rates are published around 11:55 a.m. in London, or the GMT +1 timezone. From this point forward, the published LIBOR rates will act as the global standard until new rates are published at approximately the same time the next day.

Within ICE, an administrative body known as the ICE Benchmark Administration (IBA) is responsible for overseeing the implementation of the methodology used to establish LIBOR rates. For example, the IBA directly selects the banks that will be offered the chance to submit an interest rate quote as part of the calculation process. Currently, the IBA gives preference to banks that have an influential role in the London financial marketplace. The IBA undertakes an annual selection process to determine which specific banking institutions will be used to establish this critical measure.

As part of their efforts to continually refine and develop the process used to calculate LIBOR, the IBA has proposed a variety of unique systems to ensure that LIBOR rates are as reflective of current economic trends as possible. Consequently, the LIBOR should always be considered a fluctuating unit of measure rather than a static entity.

Once the daily LIBOR rate is established, its impact can be felt throughout the global economy at large. LIBOR is utilized in a variety of scenarios throughout the world on a daily basis. For example, LIBOR directly impacts a variety of interbank activities and products, including interest rate swaps and interest rate futures. Similarly, a number of commercial banking products that do impact consumers are also influenced heavily by LIBOR. One of the best examples of this is variable rate mortgages.

For many individuals, the impact of LIBOR is felt in a variety of indirect means. One of the most widespread examples of LIBOR influence on the U.S. domestic population is student loans. The interest rates attached to loans used as a supplement for educational expenses directly incorporate LIBOR into interest rate calculations.

Given the fact that LIBOR plays such a crucial role in the global economy, it should come as no surprise that allegations have surfaced at times relating to the "rigging" of interest rates. The most notable of such scandals occurred in 2008 when investigative reporting revealed accusations focusing on a complex system of rate manipulation. As a result, a number of major international banks such as Barclays, the Royal Bank of Scotland, UBS and Deutsche Bank were sanctioned with heavy fines.

The fallout from this particular controversy was instrumental in LIBOR's transition from the British Banking Association to the Intercontinental Exchange that oversees rates to this day.

As the complexity of global finance continues to increase, it remains to be seen as to whether or not LIBOR rates will continue to play as influential a role in the world economy as they do currently. It is important to note that the credibility of LIBOR was critically damaged during the 2008 rate-rigging scandals. Although LIBOR's reputation has largely recovered, there remains a degree of trepidation for many who understand too well just how much influence this particular rate wields. As such, it is not a certainty that LIBOR will continue to act as a global consensus indefinitely. For the time being, however, LIBOR acts as a crucial anchor that keeps the intricacies of modern financial activity operating in tandem.