Page 35 - Banking Finance February 2023

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Overnight Index Average (SONIA), in Japan - Tokyo Britain Pound. Which then became the default standard
Overnight Average Rate (TONAR) and in Switzerland - Swiss interest rate for transacting in the interest rate and
Average Rate Overnight (SARON). currency-based financial dealings between financial
institutions at the local and international levels.
Understanding LIBOR
But major change happened in the aftermath of the scandal
LIBORofficially now known as ICE LIBOR stands for
in LIBOR, Britain's primary financial regulator, the Financial
Intercontinental Exchange London Interbank Offered Rate
Conduct Authority (FCA), shifted supervision of LIBOR to a
is the interest rate at which banks can borrow money
new entity, the ICE Benchmark Administration which is an
(unsecured funds) from other banks in the London interbank
independent UK subsidiary of the private U.S.based
market for a specified period of time in a specified currency.
exchange operator Intercontinental Exchange or ICE.
Here important point to note is that banks are submitting
rates at which they 'can borrow' not the actual rates at
Calculation of LIBOR
which transactions are taking place.
Every day 18 international banks submits their quotes of the
The benchmark rate LIBOR was being published on daily rate on which they are ready to pay if they borrow funds
basis once a day at around 11:55 a.m. London time and from other banks on the interbank lending market in London.
calculated for seven different maturities which are 1 Day, 1 To help guard against extreme high or lows that might
Week, 1M, 2M, 3M, 6M, 12M and for five currencies: USD, influence the final rate Intercontinental Exchange (ICE)
GBP, EUR, JPY and CHF. Total of 35 different LIBOR rates Benchmark Administration uses "trimmed mean" method,
calculated and reported on each business day by where in trimmed mean is calculated by discarding the top
combination of 7 Maturities and 5 Currencies. 4 and bottom 4 of the submitted interest rates and then
taking an average of the remaining middle 10 submissions.
The London Interbank Offered Rate was used to price This calculation reduces the impact that any single
adjustable-rate mortgages, asset-backed securities, credit contributing bank can have on the final officially published
default swaps, municipal bonds, private student loans and rate.
other types of debt. As of 2019, $1.3 trillion of consumer
loans and $1.2 trillion worth of residential mortgage loans Importance of LIBOR
had been priced using LIBOR.
The LIBOR was important not because banks used to
transact with each other at announced rate but LIBOR
When there is an application for a LIBOR then Financial firm
derived its importance from its widespread use as a
would refer LIBOR for the specific period and will add an
benchmark for many other interest rates products in which
additional percentage. For example, a consumer loan based
business was being carried out. According to a U.K. Treasury
on 3 month LIBOR plus 2.5 percent has come for
report, USD300 trillion in financial contracts were tied to
consideration. At that time 3-month LIBOR is 0.20 percent,
LIBOR. And that did not even include rates on uncounted
then effective rate for the loan is 2.70 percent. Other
tens of billions of dollars of adjustable rate home mortgages
factors such as credit risk, term of the loan, income etc are
and other consumer loans all around the globe in which
also factored in.
LIBOR, in one way or the another, was referenced. LIBOR
was established as a standardized benchmark for pricing
Origin of LIBOR floating rate corporate loans. LIBOR was instrumental in
During 1980s the uniform measure for interest rate became development of various financial products such as forward
necessary for Financial Institutions as the market for rate agreement, interest rate swaps etc.
Interest rate based products was evolving in that era. In
1984 the British Bankers' Association (BBA) which Various types of loans were linked or priced using LIBOR such
represented the banking and financial services industry - set as Corporate Debt, Adjustable-rate Mortgages, Asset-
up BBA interest-settlement rates. Further developments led backed Securities, Municipal Bonds, Interest Rate and Other
to the evolution of BBA LIBOR in 1986, initially with only Derivatives Products, Private Student Loans, Personal loans
three currencies the US Dollar, Japanese Yen and Great and Other Types of consumer loans etc.

30 | 2023 | FEBRUARY | BANKING FINANCE