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Wednesday, 4 July 2012

A Simple Guide to the Libor Rate

by Viva AvasthiThe biggest issue being discussed on British news lately is the Barclays scandal which involves accusations that the Libor rate was fixed by Barclays to make the bank falsely appear to be doing well. The questions that arose in my mind were, "What is the Libor rate?" and, "Why should I care if it's been fixed by Barclays?"No doubt many of you have also been wondering what this mysterious but supposedly highly important Libor rate is. Alongside informing myself on the subject, I thought it might be good to clear up the facts for you as a reader, too. Don't worry though, this article won't be too long and it'll be fairly easy to get to grips with.

So what is the Libor rate?

The LIBOR rate (London Interbank Offered Rate) is exactly what its name suggests; it is a reflection of the rate at which banks are willing to lend to each other in the short term. This interbank lending is essential for the banks to function properly because it allows for unsecured (i.e. short-term) lending so companies can borrow and lend money without having to issue bonds. Due to the fact that everyday a bank's balance sheet changes as people make deposits and withdraw money, it is important for banks to be able to borrow from one another at short notice so that they can be sustained, or as it is termed in the news, 'stay afloat'. Although interest rates are perceived as being the most important rate issued by the Bank of England or the Federal Reserve, the Libor rate is in actuality more useful as an indicator of the real cost of borrowing. This is because it is based on the level at which banks have been lending to each other so shows how much they trust each other. It is calculated at 11 o'clock in the morning in ten currencies and fifteen timezones - so it's not just the UK that it affects - in fact, it could be called the world's most important number!

What does it do?

It plays a key role in the money markets as it influences the rates of lending, especially of mortgages, offered to consumers. This is because it is a rate that essentially measures how much banks trust each other, and because the public and businesses rely on banks for completing transactions, the Libor rate also affects how much lenders lend.

So in essence, because the Libor rate shows how reliable a bank is, Barclays manipulated it to make itself appear to be more reliable so that nobody would be afraid of borrowing from and lending to it.

How does the Libor rate affect me?

Just as other of economics-related issues tend to have a 'trickle down' effect, the Libor rate does, too. Since the Libor rate affects how businesses and individuals borrow, it impacts each of us as the interconnected world exchanges goods and services. It could potentially affect prices of goods, wages, and so on.

Although the effect of Barclays' manipulation of the Libor rate should be minimal in terms of the rate itself, because we're dealing with hundreds of trillions of pounds of debt stock valued by the Libor rate, even a small change in the rate has huge implications.