LIBOR, stands for the London InterBank Offered Rate,
provides a measure of how much large banks would have to pay to borrow money
from other large banks on an unsecured basis. Banks rely on this money to lend
to customers and businesses and so it is a vital indicator of confidence in the
banking system.
It is the most common reference base for pricing interest
rate sensitive instruments (e.g. it is the key rate in the interest rate swap
market, whilst corporate loans and even some adjustable rate residential
mortgages are pegged to LIBOR).
LIBOR has hit the headlines recently following the £290m
fine imposed on Barclays by the Financial Services Authority along with US
regulators, after an investigation found they had been attempting to manipulate
the level of LIBOR.
Here, we take a look at how LIBOR is calculated, how it
could have been manipulated and the potential impact on investors as a result.
What rates are submitted and by whom?
• LIBOR is calculated every day (at around 11am) in 10
different currencies, with 15 loan maturities quoted for each currency (ranging
from overnight to one year). Therefore, 150 rates are calculated in total every
day.
• For each currency, there are a panel of banks chosen as a
reflection of the largest and most active banks in that currency.
• Each day, every one of those banks is asked to provide a
submission of the rate at which they could borrow funds in that currency over
the relevant maturity.
• Just as customers with bad credit records have to pay
higher interest rates, large banks which are deemed in poorer financial health
are charged more to borrow.
How is the LIBOR rate then calculated?
• For each maturity, the submissions from the panel of banks
are ranked from the highest to lowest.
• The highest 25% and the lowest 25% of submissions are dropped
and the remaining rates are averaged.
• This average is reported as the LIBOR rate for that
maturity on that day.
• Whilst extreme quotes are cut out during the calculation
of LIBOR, all rates are subsequently made public as part of the monitoring of
the system.
How can LIBOR be manipulated?
• The fact that the panel of banks who help set the rate are
also invested in financial instruments which are tied to LIBOR, means that they
potentially have an incentive to misquote.
• Such behavior can be limited to a certain extent by the
removal of the extreme quotes as part of the calculation methodology noted
above.
• However, even the average rate could theoretically be
manipulated if enough banks collude or if a sufficient number change their behavior.
