With the end of 2021, “the most important number in the world” remains in history. This has been LIBOR for banks and their customers for more than 40 years.
The acronym stands for London Inter-Bank Offered Rate, or London Interbank Offered Rate, to which loans of more than $ 300 trillion were once tied.
What exactly is LIBOR?
This is the interest rate at which major international banks provide financing to each other. It is often at the bottom of a huge number of loan agreements ranging from credit cards, from mortgages to those granted to businesses.
In these contracts, it is written that the interest that the end customer has to pay is LIBOR + margin.
Thus, if the current value of the indicator is 1% and the margin is 5%, then the total interest rate reaches 6%. As LIBOR changes every day, this also happens to end customers, although not with the same intensity.
For this reason, the decisions of the banks involved in the formation of the indicator affect the lives of ordinary people and businessmen, because these decisions determine how much of the money they have goes to interest payments.
How is LIBOR formed?
To form interest on LIBOR for a given currency and loan term, a daily survey is conducted with banks with the question “How much do you think it will cost you today to borrow funds from other banks on the interbank market?”.
That is, the quotation is determined entirely based on a study in which banks say at what price they expect to be financed, and not on the real values, the real values at which this happens.
To avoid speculation in determining the index, the highest and lowest quotations are removed and an average value is provided. All this without regulation by the central banks, which should have a leading role.
Why are LIBOR retiring and the scandal cost banks over $ 9 billion?
Ideally, banks participating in the interest rate survey (in different currencies and with different maturities) should reflect their real expectations.
The period 2008-2012 coincided with the financial crisis and the Great Recession, several revelations were made that LIBOR is in fact “the interest rate at which banks do not lend to each other.”
This definition was given by the Governor of the Bank of England (Central Bank of the United Kingdom) in 2008, noting that LIBOR cannot be relied on as an objective indicator.
The reason for this is an investigation by the Wall Street Journal of the same year in 2008, which states that many banks involved in the formation of LIBOR declared far lower interest rates than those which they financed.
In this way, financial institutions have masked their deteriorating situation on the eve of the crisis and hence misleading many investors.
After the scandal
As a result, legislators and regulators in developed economies have taken action to limit the possibility of this happening again in the future. The main conclusion that has been drawn is that it cannot be left to the banks without any supervision to set interest rates to which loans over $ 300 trillion are tied.
In 2012, a law was passed in the UK, according to which the management of the process of forming LIBOR is taken over by a newly established state regulatory body.
In the European Union 2016, a regulation in the same direction was adopted.
What replaces LIBOR?
For assets denominated in euro, this is the ESTR index, which they replace. The European LIBOR EONIA, reflects the price at which banks are financed. so-called overnight or one-day loans.
For loans with higher maturity, EURIBOR is used, which also reflects the changes in the European regulation from 2016 and is regulated by the ECB.
In the United States, the new index is the SOFR, which measures the cost of government-backed government debt securities, as monitored by the Federal Reserve in New York.
Both new indices apply to new loans from 2018 and will continue to operate in the future.
Until 2023, LIBOR will remain a reference value for some of the loans already granted, but due to regulatory monitoring, there is no way to speculate on interest rates.
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