LIBOR: The London Interbank Offered Rates

The London Interbank Offered Rates (LIBOR) can be described as the wholesale cost of money in the London interbank money market. Though the LIBOR rates are fixed in the United Kingdom, American consumers need to understand how LIBOR works, since LIBOR is used as an index in the pricing of many types of consumer loans in the United States.

How LIBOR Works

LIBOR is the average interest rate charged when banks in the London interbank money market borrow unsecured funds from each other. There are many different LIBOR rates (maturities range from overnight to 12 months) for numerous currencies, including Eurodollars. A Eurodollar is an American dollar on deposit in any bank outside the United States, and is therefore not subject to regulation by the U.S. Federal Reserve.

LIBOR rates are fixed every UK business day by the British Bankers' Association (BBA), a not-for-profit trade association.

Just before 11:00 a.m. GMT, the BBA polls a specific panel of highly reputable, high-volume banks which participate in the London wholesale money market. The BBA finds out the rate at which each bank on the panel could borrow Eurodollars from other banks, for specific maturities. The BBA figures out the central tendency -- the interquartile mean -- for each maturity, then publishes these rates at about 11:30 a.m. GMT.

Three American banks are included in the panel surveyed by the BBA for Eurodollar fixing: Citibank, Bank of America and JP Morgan Chase. There are also 13 non-U.S. banks surveyed for Eurodollar fixing in London, bringing the total Eurodollar panel count to 16. To get the interquartile mean for each maturity, the BBA starts with the 16 rates, discards the four lowest and four highest rates, then determines the average of the remaining 8 rates.

Back in the mid-1980's, the international banking system adopted LIBOR as a much needed benchmark for short-term, interbank loans. The LIBOR rates are now globally recognized indexes used for pricing many types of consumer and corporate loans, debt instruments and debt securities across the globe. For example, LIBOR is used as a benchmark for the vast majority of interest-only loans in The United States.

Many American banks index their loans and credit card products to the Fed Prime Rate, but more and more banks are turning to LIBOR indexing in lieu of indexing to Prime. Banks like LIBOR rates because they change in response to current credit market conditions and are updated every UK business day. The United States Prime Rate, on the other hand, moves in tandem with the Federal Funds Target Rate, which is usually reviewed by the Federal Reserve's Federal Open Market Committee (FOMC) every six weeks.

The U.S. Prime Rate and the benchmark Federal Funds Target Rate are both set by America's central bank: the United States Federal Reserve. The LIBOR rates, on the other hand, are not controlled by the central bank of the United Kingdom (the Bank of England.)