The London Interbank Offered Rate, or Libor, will be phased out in its entirety come June 30 of this year, ending its almost 40 year history as a primary benchmark in the international interbank market, a history corrupted over the last few years by several notable scandals. Firstly, Libor, in many respects, serves as an alternative to the US’s federal funds rate as a benchmark for global short-term interest rates that other depository institutions and lenders base their own interest rates off of. It came into formal use in 1986 under the supervision of the British Bankers’ Association, and can be formally defined as, “The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11 AM London time.”
Although this may sound similar to how the federal funds rate is found through primary dealers’ transactions, what’s important to note is that Libor is calculated for five different borrowing periods, from overnight to a year, and that Libor differs from currency to currency because it’s the result of separately asking banks within their respective countries the interest rate they would be willing to pay over the aforementioned borrowing periods. Participating banks are asked the following question, “At what rate could you borrow funds, were you to do so, by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11am?” Or, in other words, at what rate would the bank be willing to lend to other banks of similar size. “Participating banks” are a group of large depository institutions similar to primary dealers in their respective countries. The UK, for example, has 16 member banks, while the US has 17 member banks, each bank giving the hypothetical rate they would set for different borrowing periods. Before December 2021 there were five participating currencies in Libor: the US dollar, the British pound sterling, the Euro, the Japanese yen, and the Swiss franc. Until June 30, however, it is just the US dollar that remains. Remember that member banks set the Libor for their respective currencies, so there’s not one Libor, but a Libor for each participating country. In any case, the banks’ responses would be averaged out for a country’s Libor.
Against such a backdrop, the financial world was deeply shaken in 2012 when the US Department of Justice began a probe into possible Libor abuse. Months later in June of 2012, the DOJ alongside the US’s Commodity Futures Trading Commission and the UK’s Financial Services Authority sued Barclays, the UK’s second largest bank by total assets, for a combined nearly 400 million pounds. As it turned out, during the Global Financial Crisis, Barclays had both reduced its submissions to Libor and made their rates artificially higher, all to make the bank seem stronger than it actually was. This was only compounded when UBS, in December of the same year, was found guilty of the same misconduct during the same time frame as they tried to profit from higher rate submissions, being fined a total of 160 million pounds.
This series of interest rate fixing during the Great Recession proved to be incredibly problematic to the financial world, given that about $350 trillion in derivatives is tied to Libor, including around 60% of adjustable rate mortgages and nearly all subprime mortgages in 2008. Soon after the investigations’ conclusions, the apparent flaws in Libor were exposed, that is, the relative ease for banks to simply lie about the interest rates that averaged out to become Libor, especially since the banks weren’t actually trading under such an interest rate but were simply answering a hypothetical question. With this exposure came the ultimate process of phasing out the use of Libor, a process that ten years later will finally find closure when in just a few months the US will leave the interest rate’s guidance. Although playing a pivotal role in global economics and cash flows for generations, Libor and its faults may be looked at, at best, as a stepping stone towards more ideal configurations of the circulation of liquidity in the international banking system.
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