Topics: Debt, London Interbank Offered Rate, Basis point Pages: 5 (1559 words) Published: June 23, 2012

LIBOR stands for the London Interbank Offered Rate published by the British Banker’s Association. LIBOR indicates the average rate that a participating institution can obtain unsecured funding for a given period of time in a given currency in the London money market. The rates are calculated based on the trimmed, arithmetic mean of the middle two quartiles of rate submissions from a panel of the largest, most active banks in each currency. In the case of the U.S. LIBOR, the panel consists of fifteen banks. These rates are a benchmark for a wide range of financial instruments including futures, swaps, variable rate mortgages, and even currencies.

The LIBOR represents the rate at which banks lend to one another. Due to some regulations (reserve requirements) imposed by US banking authorities on US banks, a large market for US Dollar deposits developed outside the US. The Eurodollar market in London became the place where Dollars were traded and the London InterBank Offer Rate (LIBOR) became the benchmark price for Dollar deposits. Today the BBA LIBOR rate is a key reference rate for many loans in the US and elsewhere, including many mortgages.

During normal market conditions banks lend to one another at rates slightly above Treasury Bill rates. There is a modest amount of risk of lending money to a bank, since unlike the US Treasury, banks occasionally go out of business and are unable to repay their loans. But during crises in financial markets, when banks are in great difficulty, the LIBOR rate rises relative to Treasury Bill rates (increasing the TED spread) to reflect the additional risk of lending to banks.


Libor may not be accurate as a measure for borrowing rates faced by either the Libor-panel banks or for the market as a whole. There are a number of reasons why average bank wholesale borrowing rates may differ from the Libor fixing rate of the same maturity. Generally, these factors will make actual Libor-panel bank borrowing rates and market-wide bank borrowing rates higher than our measurements based on bank borrowing rates that we identify. The primary reasons for discrepancies include:

1. Libor is an offer rate. Libor is a rate at which banks estimate they would be offered unsecured funds by counterparties. Given the presence of a bid-ask spread, this would lead Libor to be higher than the average observed loan rate. When bid-ask spreads are large, this difference will increase. Although we do not have direct data on interbank bid-ask spreads, given the widening of such spreads in other markets during the crisis, it is expected that these spreads would have increased in the interbank market also. 2. Borrower sample differences. Most actual borrowing is by a larger cross-section of banks, which may be of higher or lower credit quality on average than banks in the panel. Borrowers may also be foreign bank organizations (FBOs), which may not have access to domestic retail dollar funding and be more desperate to borrow in wholesale markets than domestic banks. 3. Lender sample differences. Banks in the Libor panel are asked to report the rate at which they can borrow from another bank. Much bank wholesale borrowing is from nonbank lenders such as money market funds, which may have less market power than large banks and may lend to banks at rates even below banks bid rate in the interbank market. We can somewhat control for this in our analysis by examining lending in fed funds, which is defined to be lending by banks or GSEs, and lending in Eurodollars, which may be by nonbank lenders. 4. Selection effect within the Libor panel. Even if we just restrict attention to borrowing by Libor panel banks, the Libor fixing rate is based on a trimmed mean across all institutions, some of which may not borrow in the term interbank market on a given day. The banks that do borrow may have a lower or higher cost of funds than the panel mean. 5. Size effects. The Libor survey asks...
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