The London Interbank Offered Rate, or LIBOR, has been around for over 40 years. It acts as an important benchmark to set interest rates for adjustable-rate loans, mortgage products, and setting prices for corporate borrowers.
After decades of service, this critical measure is being retired by the financial industry. As banks change the way they do business, LIBOR has become less accurate as a measure of the industry. Combined with more modern alternatives and a history of scandal, LIBOR is on the ropes.
What is LIBOR?
LIBOR works by providing loan issuers with a benchmark for interest rates charged on different financial products. It works by collecting daily estimates from 18 different global banks on the theoretical interest they would charge on certain loan maturities, taking into account local economic conditions. What the banks turn in is then averaged together to and given as a range of LIBOR rates.
LIBOR became an international benchmark in 1986, but its reach goes back even further to the 1960s. Still in heavy use today, by 2019, $1.3 trillion in consumer loans and $1.2 trillion in residential mortgage loans are based on the metric. Some of the financial products that rely on LIBOR include:
Credit default swaps
Private student loans
When you apply for a loan, the financial institution being borrowed from will take the LIBOR rate and then add a fixed percentage onto that to get the rate. If a student loan is based on the LIBOR three-month rate, which is 0.33%, plus 5%, then the total interest on the loan would be 5.33%. This is the basic loan pricing, which is then adjusted according to the borrower’s credit score, income, and the loan term desired.
Adjustable-rate products are updated at regular intervals. Changing the rate as LIBOR goes up and down changes the loan payments due each month.
How is LIBOR calculated?
Eighteen international banks submit rates that they believe they would pay if they had to borrow money from the interbank lending market in London. The rate isn’t what banks actually pay, only what they think they would pay. This speculation has made it easy to tamper with LIBOR in the past.
To keep the results from fluctuating too much, the Intercontinental Exchange (ICE) Benchmark Administration takes away the four highest and four lowest responses and takes the average.
LIBOR is calculated using five different currencies:
UK Pound Sterling
The U.S. Dollar
Controversy surrounding LIBOR
One of the reasons that LIBOR is no longer trusted is because of how easy it has been to manipulate. Barclays, along with several other large banks, submitted rates that benefited traders instead of sending rates that would realistically be paid. The scheme raked in hundreds of millions of dollars for these banks over several years.
LIBOR was also a key factor that exacerbated the 2008 financial crisis. Credit default swaps (CDS) were the biggest driver of the crisis, with risky mortgage products being insured by large institutions. The rates for CDS were set by LIBOR. When the markets crashed, banks were more reluctant to lend to each other, leading many to wonder about the impact of the LIBOR transition on the lending market.
The rates calculated using LIBOR soared because of this, pushing the crisis out across the globe. Even as global banks slashed interest rates to try to mitigate the crisis, rates dictated by LIBOR rose. Trillions of dollars in financial products were affected by the benchmark. The rising rates reduced money moving through the economy, caused a panic, and helped the market crash.
Dealing with the LIBOR transition
Each banking division has to deal with the LIBOR transition differently. Predominantly, capital markets can depend on their platform providers (Calypso Technology, Murex etc.) and are already well on the way to letting go of LIBOR processes. However, lending businesses and departments are still a long way away from becoming compliant. Every single mortgage and loan needs to be updated, predominantly manually, and moved on to a new interest rate.
Most lending departments haven’t even done an impact analysis yet, and are therefore not aware of how much work they have left to do before the end of 2021. Understanding how many mortgages and loans are going to be impacted by LIBOR reform is an essential first step in becoming compliant. CPQi can help you get started by providing an impact analysis, and then if possible, building a system that will automate the entire LIBOR transition process for you with our IBOR Transition Managed Services. If it’s not possible to digitally automate your LIBOR transition, we can provide skilled LIBOR experts at exceptional rates to help move over your loans into new interest rates.
Unlike consultancy firms, CPQi can do the work for you. We are currently managing the entire LIBOR reform process for several of the largest banks in the Americas. I’d love the opportunity to discuss how we can help you manage your LIBOR transition by providing impact analysis and automation services. Drop me an email at email@example.com or book a free consultation here to get started on your stress-free LIBOR transition journey.
Written by Mauro Mambretti, LATAM Country Director at CPQi.