Understanding BBA LIBOR1
16/10/12

On every business day in London, Thomson Reuters calculates a set of benchmark rates known collectively as the London Interbank Offered Rate (LIBOR).

LIBOR rates closely reflect the real rates of interest being used by the world’s largest financial institutions. Whereas central banks (such as the Bank of England, the US Federal Reserve and the European Central Bank) fix official base rates monthly, LIBOR reflects the rates at which these prime banks borrow money from each other each day, in the world’s 10 major currencies and for 15 borrowing periods ranging from overnight loans to 12 month. Once calculated, the LIBOR figures are then published by Thomson Reuters: they appear on more than one million screens around the world and are widely reported in the press, the wire services and online.

Thomson Reuters undertakes this work for the British Bankers’ Association.

How is it calculated?

Each day at 11:00 hrs London time the banks which contribute to the LIBOR-setting process send their interbank borrowing rates confidentially to Thomson Reuters. Thomson Reuters discards the highest and lowest contributions (the top and bottom quartiles) and then uses the middle two quartiles to calculate an average. This methodology is sometimes called a “shaved mean” or a “trimmed mean”.  This process is followed 150 times to create the day’s LIBOR rates for all 15 borrowing periods and all 10 currencies. These figures are then published by Thomson Reuters by midday.

The number of banks contributing to the process varies according to the currency. The euro panel has 15 banks; the sterling panel has 16; the US dollar panel has 18. Each follows the same procedure of discarding the upper and lower quartiles and averaging the centre quartiles to create a rate.

As well as publishing the 150 LIBOR rates, Thomson Reuters also publishes all of the data contributed by each individual bank.

The BBA publishes the full methodology used for the calculation process, the procedures to be used by contributing banks and the method used to select panel banks.  The calculation is therefore fully transparent: the markets can see not only the day’s rates, but also all of the contributed data used to calculate the rates.

Any bank may apply to join the contributor panels: there is no requirement to be in London, or a member of the BBA. Banks are selected on the basis of market activity.

The overseeing body is the Foreign Exchange and Money Markets Committee, which is a group of active market practitioners including representatives from banks, the money markets, corporate treasurers and exchanges. This body oversees the rate setting procedures, and scrutinises the rates for accuracy. Details of this are available on the LIBOR website.

How did it become so important?

LIBOR was first developed in the 1980s as demand grew for an accurate measure of the rate at which banks would lend money to each other. This became increasingly important as London’s status grew as an international financial centre. More than 20 per cent of all international bank lending and more than 30 per cent of all foreign exchange transactions now take place in London.

LIBOR rates are the basis for a range of financial instruments: derivatives based on the LIBOR rates are now traded on exchanges such as LIFFE and the Chicago Mercantile Exchange (CME) as well as over-the-counter. The rates are also used as the basis for many types of lending, from syndicated and commercial lending, to residential mortgages.

How often is this process reviewed?

The setting processes are kept under continuous review by the Foreign Exchange and Money Markets Committee. Twice a year, this committee determines the membership of each currency panel using a methodology which is published on the LIBOR website.

What does LIBOR tell us about global markets?

Rates are calculated daily from the rates at which large banks borrow on the money markets. It is accepted as a barometer of how global markets are reacting to the prevailing conditions.

Rates were widely reported in the media throughout the credit crunch as a leading market indicator. When Bear Stearns informed investors of their likely losses from two hedge funds in July 2007 (now regarded as one of the first signs of the credit crunch) LIBOR was among the first indicators to illustrate the trends in the markets that led to this event. When Lehman Brothers failed in 2008, LIBOR was indicating the very significant pressure on the credit markets.

The Wheatley review

On 28 September 2012 the Wheatley Review published its final report ‘The Wheatley Review of LIBOR’, which included a 10-point plan for comprehensive reform of LIBOR.

The BBA worked very closely with the Wheatley Review of LIBOR and believe its final report to be an essential step. The BBA has strongly stated the need for greater regulatory oversight of LIBOR, and tougher sanctions for those who try to manipulate it. The BBA Council has indicated it would support any recommendation that responsibility for LIBOR should be passed to a new sponsor.