What is Libor?

Just like you and I borrow from the bank at certain interest rates, banks too, have to borrow from each other on a daily basis. Libor stands for the London Interbank Offering Rate. It is the interest rate at which banks agree to lend to each other. They lend over various time periods, including overnight, three months and 12 months.

Is Libor different to official base rates?

Yes, official base rates are the rates at which central banks, like the Bank of England and the Federal Reserve in New York, are prepared to lend to other banks. Official rates are typically set monthly, whereas Libor rates are always changing and are quoted on a daily basis. Derivatives based on Libor rates are now traded on various exchanges such as Liffe and the Chicago Mercantile Exchange.

Who sets Libor?

Libor is set by the British Banking Association, which meets every morning at 11am with representatives of 16 different banks to decide how much they are willing to lend, and on what rate. It uses their individual responses to calculate an average which then becomes that day’s Libor rate.

Why is Libor being talked about?

Ordinarily, banks lend to each other every day and details of those borrowings never hit the headlines because they are routine transactions. Because of the credit crunch, however, banks have become scared of lending to each other because they are unsure of who is sitting on what losses. So overnight and three-month Libor have become a closely watched gauge of the general nervousness of banks and their willingness to lend.

What effect has that had on Libor?

The effect has been to make Libor rates rise sharply and in an erratic manner, reflecting the panic and uncertainty in the market. At one point, Libor was 113 basis points above the UK base rate, its widest gap since September 1986. European Libor rates, Euribor, have not risen as sharply because the European Central Bank took early steps to alleviate the panic by pumping billions of euros into the market.

What has been the effect of the Bank of England’s action yesterday on Libor?

By agreeing to lend money on a three-month basis, instead of just its daily or weekly timeframe, the Bank of England has alleviated the pressure on the interbank lending market. Libor rates have come down, as banks can now go to the Bank of England to borrow. Reflecting this, three-month Libor rates fell to 6.55 per cent yesterday, from 6.75 per cent on Tuesday – according to Reuters data, its lowest level since August 15 – as markets breathed a sigh of relief. Overnight Libor rates are typically lower as it is less risky to lend for shorter periods of time. Yesterday, they were fixed at 5.88 per cent versus 6.14 per cent.

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