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