The Dichotomy of Libor Essay

Submitted By ThomasNisbet79
Words: 3510
Pages: 15

LIBOR is the London interbank offered rate and though the name implies one rate it is responsible for setting about 150 different rates tied to \$350 to \$800 trillion of currency worldwide. The rate affects derivatives, mortgage rates, interest rates, currency evaluation, loans, and much, much more. The average American might not be familiar with how the rate operates, what the rate does, and how it affects them. Recently, the LIBOR rate was shown to be fixed by Barclays, Bank of America, Citibank, JP Morgan Chase and 14 other major financial institutions . In the following pages, we will explain LIBOR; provide a brief history, describe the potential negative and positive effects of fixing the rate, discuss possible consequences and changes to the index. For the purpose of this paper, the LIBOR rate will refer to the 3-month rate and though LIBOR is an index of rates it is generally referenced in the singular.

A Brief History of LIBOR Everyday around 11 am (GMT) banks call the British Bakers’ Association (BBA), the publisher of the LIBOR rates, to report their cost of borrowing money from other financial institutions. The BBA takes the information removes the top 25% of the highest and lowest rates and averages the middle 50%. The average rates are released at 11:30 am and the adjustments are made to the markets based on their particular LIBOR rate . The scandal involved banks moving interest rates up and down in order to positively influence the bank and its assets. LIBOR is built to be an average of rates as described above but one bank can in certain cases manipulate the rate as explained in this example: “Suppose that 4 banks report an interest rate of 3%, the next 10 banks report an interest rate of 8%, and 4 banks report an interest rate of 10%. The dollar LIBOR would be calculated by throwing out all of the 3% and 10% responses because the calculation throws out the highest and lowest 4 responses. In this example, the remaining 10 responses are all 8%, so the average would be 80/10 = 8%. LIBOR would be reported at 8%. However, if a bank that would have reported 10% wants to lower the LIBOR, and the bank lowers its bid from 10% to below 8% (for the sake of this example, assume the response is changed to 2%), the average will change, even though the bank’s response is still thrown out. Why? Because one of the 8% responses is now among the highest 4 responses, and one of the 3% responses is in the middle 10. The average is now 75/10=7.5%. In this example, a single bank could move the index from 8% to 7.5% ”.
The LIBOR rate could be the single most influential rate in the world, using the low-end estimate of \$350 trillion assets tied to the rate would be enough money to finance the United States Government for 96 years. The immense size of assets tied to LIBOR means a fluctuation in the rate could have far-reaching effects. A low LIBOR rate means lower rates on consumer loans, bonds, and commodities. The low rate leads to two outcomes. First, the borrower of the money, the consumer, saves on interest payments and has an inexpensive ability to finance operations, whether it be buying or refinancing a house, or paying for a municipal project to name a few. Second, the lower rate means that the bank (including its investors, stockholders), or bondholders receive less rate of return and the lower rate cuts into profits. A higher LIBOR rate has the converse effect, the price to borrower is higher but the rate of return to investors is higher. Higher LIBOR rates can lead to banks making more money as the cost to borrow funds increase greater to consumers than to lending institutions. The fluctuation of rates can trigger or affect other financial instruments as well. Credit default swaps, derivatives, future contracts, bond rates, options, and others are all affected by the changes in index rates such as LIBOR.
The rate fixing scandal started in 2005 and continued until 2009. Barclays, which