Q: What in the world is LIBOR? Is it like a liger? Because that would be awesome.
A: LIBOR stands for “London Interbank Offered Rate,” and it gives the interest rate that major banks in London would pay to borrow money from one another. Technically, the LIBOR is a collection of a bunch of different interest rates for borrowing different currencies and for different periods of time.
Q: Uh, I don’t know if you’ve noticed this, but I’m not a bank in London…so how on earth is LIBOR relevant to me?
A: LIBOR is relevant because it’s often used as a proxy for a “risk-free” interest rate. (A risk-free interest rate represents the interest rate that somebody or something could get if it could guarantee that the loan would get paid back on time. With respect to the state of banks nowadays, I find this concept hilarious.) Because of this, many contracts between businesses and their suppliers/customers are tied to the LIBOR, and variable-rate mortgages, student loans, etc. often have interest rates that are indexed to LIBOR. So, you care because the LIBOR likely impacts your cost of borrowing if you are an individual or a business.
Q: How is the LIBOR calculated?
A: Glad you asked, because this is the fun part. Normally, interest rates are reported based on actual economic transactions- for example, if an interest rate on a mortgage is 6 percent, then mortgages are actually being written at 6 percent, and this 6 percent was arrived at via some sort of supply and demand equilibrium. Apparently this process isn’t British enough, so instead the LIBOR is arrived at by asking banks “hey, so, hypothetically, if you were to borrow money from other banks, what interest rate do you think you could get?” and then tallying the results.
Q: Okay, that seems a little weird, but it’s been done that way for a while without incident, right?
A: Since 1986 or so, yes, at least theoretically.
Q: So what’s the problem?
A: So say you were a bank that had assets whose values were tied to the LIBOR. Would you report your LIBOR estimate correctly or might you give a value that made your stuff worth more?
Q: Well, I’m not a douchebag, so…
A: Remember, I said “you were a bank.”
Q: Oh, right. So, yes, I would probably be shady if it made me a profit. Do banks actually do this?
A: Apparently so. At the very least, Barclays has come forward and spilled the beans to regulators, and there’s no reason to believe that they were the only ones behaving poorly.
Q: So let me get this straight- I’ve been paying higher interest rates on all of my loans because these bankers wanted to make an extra few bucks on top of their already inflated salaries and bonuses?
A: Sometimes, but perhaps not always. The thing is that sometimes the bankers had an incentives to claim interest rates that were too high and sometimes they had incentives to err on the low side. For example, Barclays is accused of stating artificially low interest rates in order to make it seem healthier than it was, since why would people lend to them so cheaply if they didn’t believe it was a safe investment?
Q: So these d-bags could have actually done me a favor, at least as a borrower rather than a lender? Whatever, I’m still pissed about the possibility of being financial road kill in these guys’ drag race.
A: That’s not a question.
Or, if you prefer, in picture form, courtesy of The New York Times:
I suppose, in this context, a picture is either worth 1000 words or a few hundred basis points.