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Understanding the LIBOR Scandal

From the Peterson Institiute for International Economics by Juan Carlos Martinez Oliva:

The Barclays scandal over manipulation of the LIBOR (an acronym which stands for London InterBank Offered Rate) has put this important monetary indicator in the spotlight in recent days. The LIBOR rate may not be well known to people outside the financial sector, but it affects most people’s lives directly or indirectly, underpinning hundreds of trillions of dollars in transactions across the globe. It represents the primary benchmark index for pricing a large variety of consumer and corporate loans, debt instruments, and debt securities. It also represents the reference indicator for settlement of interest rate contracts on many of the world’s major futures and options exchanges. It is mentioned in standard derivative and loan documentation, and is used for an increasing range of such retail products as mortgages and college loans. More broadly it can also be viewed as an indicator of banking conditions, and of market expectations for central banks’ monetary stance. Following the Barclays revelations, it is therefore imperative that a review be undertaken aimed at fixing the mechanism of LIBOR and protecting it from manipulation. A thorough study of regulatory issues associated with LIBOR is also important to prevent future failures in the regulatory supervision of wholesale conduct.

LIBOR is basically an indicative average interest rate at which a sample of major banks (the so-called panel banks) agree to lend each other unsecured funds on the London money market. Accordingly, it represents the lowest real-world cost of unsecured funding in the London market.

LIBOR is not a single rate. Indeed, there are no fewer than 15 different maturities (ranging from overnight to 12 months) and 10 different currencies for which it is calculated; 150 rates are therefore calculated each business day. The official LIBOR interest rates are daily announced at 11:00 a.m. GMT by Thomson Reuters on behalf of the British Bankers’ Association (BBA, see www.bbalibor.com).

Just before 11:00 a.m. GMT, the BBA polls a specific panel of highly reputable, high-volume banks that participate in the London wholesale money market. The BBA finds out the rate at which each bank on the panel could borrow from other banks, for specific maturities and currencies. The BBA estimates the central tendency—the so-called interquartile mean—for each maturity, and then publishes these rates at about 11:30 a.m. GMT.

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