A V Rajwade: The good old LIBOR

WORLD MONEY

Ever since the birth of the off-shore dollar market, back in the 1960s (when it was known as the eurodollar market), the LIBOR, London Interbank Offered Rate, has been one of the pillars of the international financial market. It is probably the most used benchmark for the pricing of loans as well as the floating rate in the interest rate swap market. Since, at least in theory, it represents the cost of borrowing dollars in the offshore market for a bank, most loans were, and are, priced at a spread over LIBOR: the spread depends on the credit risk in the transaction. Given also the huge size of the interest rate swap market, the aggregate contractual obligations using LIBOR are in trillions of dollars.

The LIBOR's popularity has persisted despite the weaknesses inherent to the authentication of the number:

The most used contractual benchmark is the BBA (British Bankers Association) LIBOR. This is published at around 11 am London time, that is, before the opening of the US market;

It is a polled rate on the basis of the quotations given by a panel of 16 large global banks in the city of London, only three of them American.

Between 11 and 11.10 London time, the 16 banks report to BBA the rates at which they are willing to offer dollars for different maturities, to other banks in the market.

BBA ranks the quotations in order of magnitude, ignores the four highest and four lowest and averages the middle eight which then becomes the BBA LIBOR.

The very popularity of the BBA LIBOR is an indicator of the reliability of the number as representing the cost of borrowing short term funds. To be sure, there were always issues in relation to the applicable interest rates on LIBOR-linked loans. Where there was a single lender, he would use his own marginal cost of borrowing short term funds as the LIBOR and prescribe the applicable interest rate after adding the contracted spread. There were some problems in the case of syndicated loans. Not all the banks in a syndicate would have an identical credit standing and, in practice, their cost of funding differed. On the other hand, the LIBOR for a particular interest period had to be identical for the entire syndicate and was typically calculated and advised by the agent bank: if a particular bank's borrowing cost was higher, it earned a narrower spread. In the case of syndicated loans, two practices were and are common