Uncovering the Mysteries of LIBOR

by Brad Sorensen, CFA, Director, Sector Analysis, Schwab Center for Financial Research
October 10, 2008

In a market environment like this, terms that are usually confined to the inner workings of the financial world become much more common—prompting investors to question what, exactly, the meanings behind these phrases are. Lately, one of the most commonly heard terms has been the LIBOR rate. What is this seemingly all-important number that had toiled in obscurity until the credit crisis hit?

LIBOR stands for the London Interbank Offered Rate and it is the rate that banks charge each other for borrowing funds in the London wholesale market—basically, the amount it costs one bank in Europe to borrow funds from another. It is calculated once a day by the British Bankers' Association which surveys 16 major banks and takes the mean of the eight middle values.

When looking at the LIBOR rates (different rates for different time horizons), especially in this environment, we can see that elevated levels compared to historical levels indicate more fear among banks. If they are charging higher levels of interest in order to loan money to their fellow banks, it is an indication of high concern about borrowers' abilities to repay loans.

So, why do we care? In the current credit crisis, the LIBOR is of particular interest as it is quite high relative to where it would be in "normal" times. We are watching for the rate to come down as an indication that the long-awaited thaw in the credit markets may be occurring as banks' confidence in their fellow institutions improves. Also, many loans are set based on the LIBOR, and the elevated level it's currently at makes variable-rate loans more expensive.

In fact, so many loans—both for businesses and consumers—are based on the LIBOR that it makes the much-touted Fed rate cuts less effective than you might think. Following a move by the Fed, you can watch the reaction in the LIBOR market and get a slightly better handle on the cut's effect. An easing in the LIBOR would help those many loan rates come down, as well, further helping people access the credit they desire.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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