Libor - the London interbank offered rate - is an average short-term interest rate at which banks lend money to each other to ease their positions that affects the rate for other things.
The British Bankers Association (BBA) - the industry body - sets the rate daily using data from leading banks around the world that make up the Libor contributors.
A panel of 223 large global banks in 60 countries is surveyed daily to answer the 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 11 am?”. The BBA discards the highest and lowest rates relayed by the panel banks and uses the remaining responses to calculate the average and publish it at 1130 GMT.
Each bank must include in its own rate calculation various criteria including their own currency without trading it as forex, cash deposits and not derivatives, and rates formed only in London and not elsewhere.
This calculation is used to set a daily rate for 150 different indices that include hard currencies, bonds and derivatives maturities ranging from one day to 12 months.
Together with the Euribor, Libor is the world's benchmark for setting short-term interest rates.
How Libor affects the markets
Libor is used as a reference rate for hundreds of financial instruments and products - thus it not only affects traders' activities but also interest rates set by retail banks for customer products such as mortgage and credit cards, and their repayment costs.
In total the Libor rate affects some $350 trillion worth, as at 2012, of financial instruments, including derivatives, classified into three categories.
- Standard interbank products such as forward rate agreements, interest rate futures, options and swaps, and swaptions.
- Commercial products such as floating rate notes and certificates of deposits, syndicated and term loans, and variable rate mortgages.
- Specialist hybrid products such as range accrual notes, step up callable notes, target redemption notes, and collateralised mortgage and debt obligations.
The 2012 rate-rigging scandal
In July 2012, the Financial Times reported that rigging of the Libor rate could have been happening since 1991 (Libor was created in 1984), by panel bank members submitting incorrect information to the daily survey in order to push the calculation into providing more favourable rates and boost their creditworthiness.
Barclays Bank, one of the UK's largest retail banks operating globally, admitted in September 2012 it had tried to manipulate Libor calculation, following an investigation. It was fined £290 million by the BBA and the chief executive was forced to resign. Other British banks remain under investigation as at October 2012.
The BBA is to transfer management of the Libor to an independent UK regulator, to be appointed by the Financial Services Authority, which is seeking power to prosecute rigging and planning to overhaul the Libor. Changes are expected to include banks' daily submissions being based on actual transactions rather than theoretical and eventually published, with a three-month time lag.
In the U.S. criminal prosecutions for Libor manipulation have been in progress since early 2012. Barclays is among those that have been fined in the courts. U.S. rigging is thought to have cost £10 billion or more to the economy.