LIBOR
What is it?
An acronym. LIBOR stands for the London Interbank Offered Rate. It's the interest rate at which banks in London borrow money from each other when their borrowings aren't being backed by any form of collateral.
LIBOR is compiled by the British Bankers' Association and is released to the market at 11am each day. It's then fixed for 24 hours, but the rate can be calculated for short-term borrowing of as little as one day, or for long-term borrowing lasting for an entire year.
LIBOR is calculated by averaging rates charged by eight different selected banks. Click here for more information on how it's done.
LIBOR is the world's most widely used benchmark to determine short-term interest rates, both for lending and for use in financial derivatives such as interest rate swaps.
Only banks are able to borrow at the LIBOR rate itself. A company with a strong credit history might be able to borrow at a rate of 5 basis points (100ths of a percentage point) above LIBOR. A company with a weaker credit history might have to borrow 50 basis points above it.
What's it got to do with the financial crisis?
Once it became apparent in August 2007 that banks might be holding lots of assets of negligible value, they became a lot less willing to lend money to each other. As a result, LIBOR rates soared.
Between 2000 and 2007, LIBOR was an average of eight basis points higher than the Federal Funds Rate, according to Lehman Brothers. In August 2007, it soared to 25 basis points higher.
On 16 September 2009, the overnight dollar LIBOR rate doubled, following the collapse of Lehman Brothers. Fearing that another bank collapse would follow, banks became extremely unwilling to lend to each other, unless at punitive rates. On 18 September, the US Federal Reserve acted to try and bring LIBOR down by pumping an additional $180bn into the world's financial system in combination with central banks in the UK, Europe, Switzerland, Japan and Canada.
Following the globally coordinated bailout of the banking system and injection of $2 trillion of taxpayers' cash in October 2008, it was hoped that LIBOR would fall. And it did - after a delay. In November 2008, three-month dollar LIBOR rates plummeted to their lowest level for four years.
This was good news because a high LIBOR rate is a headache for the world's central banks. Although central banks tried earlier to move interest rates lower, using their discount windows, interest rates charged to mortgage borrowers, etc. remained stubbornly high, in line with high LIBOR rates.
High and rising LIBOR rates indicate problems in the money market, which is used by banks and companies to borrow money short term. If LIBOR is high and money market borrowing is frozen, the only source of short-term cash is central banks. In this situation, the global financial system is effectively on life support.
In August 2009, LIBOR dropped to more normal levels, indicating that a thaw was underway in the two-year-old credit freeze.
Last updated on 7 September 2009.
