How Do Banks Determine the LIBOR Rates They Submit Everyday

The London Interbank Offered Rate (LIBOR) is a critical benchmark interest rate that is widely used in the global financial markets. It is an average of several interest rates that major banks around the world agree to lend to each other.

Introduction to LIBOR

LIBOR serves as a reference rate for many financial products, including loans, bonds, and derivatives. It is published daily by the Intercontinental Exchange (ICE), based on the rates at which large banks estimate they could borrow funds from other banks in the inter-bank market. The rates are determined through a detailed process of self-reporting and averaging, ensuring transparency and reliability in financial markets.

The LIBOR Determination Process

The determination of LIBOR rates involves a complex and structured process. ICE, the organization responsible for overseeing the LIBOR calculation, employs a rigorous methodology to ensure the accuracy and fairness of the rates.

1. Contributor Banks and Currencies

ICE convenes a panel of contributor banks, which are typically major global financial institutions. These banks are asked to provide their estimates of the rates at which they could borrow funds from other banks in a reasonable market size, just before 11 AM London time. The panel includes about 11 to 18 banks from each contributing region (e.g., US, Europe, Japan) for five major currencies: US Dollar, Euro, Swiss Franc, Pound Sterling, and Japanese Yen. Additionally, the rates are provided for seven different maturities, ranging from overnight to 12 months. This process results in a total of 35 rates being updated daily.

The Interrogation Process

Given the significance of the LIBOR rates, ICE conducts a detailed and thorough interrogation of contributor banks to gather their estimates. The questions are straightforward and direct, focusing on the current borrowing rates these banks believe they could access in the market. For instance, a typical question might be:

At what rate could you borrow funds were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 AM London time?

Data Collection and Processing

Once the banks submit their rates, ICE then processes the data according to a specific methodology. The process involves dropping the top and bottom 25% of the responses, which helps filter out any extreme outliers that might skew the final average. The remaining rates are then averaged to arrive at the official LIBOR rate for each currency and term.

2. The Role of Banks in Self-Reporting

Each bank determines the rate at which it is willing to lend. This self-reporting process is based on the bank's actual borrowing and lending activities, as well as market perceptions of its creditworthiness. By providing these estimates, banks are essentially betting on how they believe they might be able to borrow funds in the market.

3. Transparency and Reliability

The transparency of the LIBOR determination process is crucial, as it ensures that the rates remain unbiased and reflective of the true market conditions. The fact that the process involves multiple banks and currencies contributes to its robustness and reliability. Furthermore, the use of a standardized methodology and the rigorous drop process help to minimize any potential manipulation or distortions in the rates.

Conclusion

The determination of LIBOR rates is a detailed and multi-step process that involves a panel of contributor banks, rigorous self-reporting, and a structured data collection and processing methodology. By ensuring transparency and reliability, the LIBOR rates serve as a vital benchmark for the global financial system.

Key Takeaways

The LIBOR rate is determined daily by a panel of major banks. The rates are based on the banks' estimates of their borrowing costs in the inter-bank market. The process involves dropping the top and bottom 25% of responses to ensure accuracy. Each bank determines its rate based on market perceptions and lending activities. Transparency and rigorous methodology are paramount to ensure the reliability of LIBOR.

Keywords

LIBOR, Intercontinental Exchange, Financial Markets

References

[1] Intercontinental Exchange. (2023). LIBOR Determination Process. Retrieved from

[2] Cecchetti, S. G. (2021). The LIBOR transition: Issues, impacts and the path forward. Journal of Financial Markets, 54, 100717.

[3] Haldane, A. G. (2017). The future of LIBOR. Economic Journal Letters, 1(1), 1-4. doi:10.1093/ijo/300013