Most people are not clear what exactly LIBOR is. Here’s a quick primer in a FAQ-like format.
Who Administers LIBOR?
- LIBOR (London InterBank Offered Rate) was previously administered by the British Bankers’ Association (website here), and was handed over to Intercontinental Exchange (ICE) Benchmark Administration (IBA) on January 31, 2014 (website here).
How Is LIBOR Quoted?
- O/N (overnight)
- 1 week
- 1 month
- 2 months
- 3 months
- 6 months
- 12 months
- USD (US Dollar)
- CHF (Swiss Franc)
- EUR (Euro)
- GBP (Pound Sterling)
- JPY (Japanese Yen)
- Day count convention
- Actual/365 for GBP, Actual/360 for all other currencies
What’s the Point of LIBOR?
- To indicate the average rate at which a contributor bank can obtain unsecured funding in the London inter-bank market.
How Is LIBOR Fixed?
- Every business day, contributor banks are asked “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 11 am?”
- Rates are submitted to Thomson Reuters between 11.00am to 11.19.59am, who will exclude the highest and lowest 25% of submissions, calculate the arithmetic mean, and publish the benchmark at around 11.45am London time.
Why Is LIBOR Frequently Used as Benchmark for Floating Rate Loans?
- LIBOR is supposed to be a proxy for the banks’ funding cost.
- Hence it makes sense for the bank to charge its funding cost + a spread, for loans to its customers.
So, What’s Wrong With LIBOR?
- It’s a hypothetical rate, banks don’t actually lend to one another at LIBOR.
- It relies on banks making truthful, accurate submissions, which turned out to be too much to ask for.
- It is popularly misconceived as a “risk-free” discount rate. Even if the rate is real, and banks are truthful, it would only reflect the average credit risk of a group of banks, which is still not risk-free.
If LIBOR Is Not an Actual Borrowing Rate, How Should I Think About LIBOR?
- Think of it as just an index
OK, What Are The Actual Borrowing Rates?
- Eurodollar deposit rates / futures
- Eurodollars are USD bank deposits outside of the U.S.
- Overnight Eurodollar tends to be slightly higher than Fed funds rate because banks in the U.S. can always borrow from the Fed if needed.
- Fed Funds rate
- Depository institutions (e.g. banks) hold balances — called federal funds — at the Federal Reserve to meet reserve requirements.
- Federal funds rate is an interest rate at which depository institutions lend balances to each other overnight (unsecured).
- Daily effective federal funds rate is a volume-weighted average of rates on trades arranged by major brokers, calculated by NY Fed using data provided by the brokers.
Any Issues with the Actual Rates?
- While the Fed funds rate is based on actual transactions, it might not be representative if there are few transactions
- With QE, banks are flush with excess reserves hence there is little borrowing/lending required.
- Since 2008, the Fed began to pay interest on excess reserves (IOER), but the Government-Sponsored Enterprises (GSEs) such as Federal Home Loan Banks (FHLB) are not eligible. As a result, the FHLB are lending out their reserves to banks at a rate below IOER, and the banks borrow from the FHLB so as to get paid IOER by the Fed on the borrowed reserves to make the spread.
How Does IOER Affect Fed Funds Rate?
- The Fed is considering using the IOER as the primary tool to move the Fed Funds rate to its desired target.
- The IOER establishes a floor on the Fed funds rate because it does not make sense for banks to lend at a lower rate since they can make more by collecting IOER from just keeping money as excess reserves.
- Interestingly, Fed fund rates are below the IOER because
- Lenders may not lend to just any bank because of credit risk concerns, and the desire to diversify their lending across several banks instead of just lending to the bank offering the highest interest rate.
- Banks may not borrow because of uncertain balance sheet impact (e.g. higher capital requirements, leverage ratio, liquidity requirements, FDIC insurance fee).
- Interestingly, Fed fund rates are below the IOER because
- The IOER was needed because with the large amount of excess reserves due to QE, the Fed was no longer able to prevent the Fed funds rate from dropping to very low levels through normal open market operations.
- With IORR/IOER was put in due to the financial crisis, the Fed is afraid of removing it now because
- Removing it could reduce even the limited trading of reserves by the FHLB, making the Fed Funds rate useless in terms of its ability to convey information.
- Money market funds could be in trouble if interest rate is near zero.
- U.S. Treasury market could be in trouble if rates were to become negative.
- Nobody dares to find out what would happen when rates go to near zero.
Where Does Prime Lending Rate Fit Into All This?
- What it is
- The base rate on corporate loans posted by at least 70% of the largest banks.
- It is reference rate for loan pricing
- How it is set
- WSJ surveys the 30 largest banks. It will change the rate when at least 70% of the submissions change.
- What it is not
- Rate that banks charge their best customers. High quality customers can borrow below prime.
- What maturity does it represent
- It is a short-term rate that is usually ~3% above the Fed Funds rate.
Is EUR LIBOR the Same as EURIBOR?
- For EUR interest rates, EURIBOR is the benchmark, not EUR LIBOR.
- Question: “At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am?”
- Submissions are due by 10.45am CET. At 11am, Thomson Reuters will exclude the highest and lowest 15%, calculate the arithmetic average of the remaining, and publish the rates.
- Act/360 day count convention
- Maturities of 1w, 2w, 1m, 2m, 3m, 6m, 9m, 12m
- Rates are spot rates for T+2 execution.
- Threshold for excluding outliers is different, 25% (LIBOR) vs 15% (EURIBOR)
- Panel banks are different. LIBOR submissions are from banks in the London money market. EURIBOR submissions are from banks in EU countries + international banks from non-EU countries but with EU operations.
- EURIBOR tends to be higher than EUR LIBOR because the larger spectrum of EU banks leads to a larger spread in terms of credit risk.