A Look into LIBOR: Its Historical Significance, Controversies, and Its Successor
For a span exceeding four decades, the financial world has leaned heavily on the London Interbank Offered Rate, fondly abbreviated as LIBOR. Its primary role was to guide the setting of interest rates for adjustable-rate loans, mortgages, and corporate borrowings. Yet, as we turned the corner into 2022, LIBOR was discontinued for issuing new loans in the United States, succumbing to an array of controversies that shrouded its last decade of existence.
Stepping into LIBOR’s shoes is the Secured Overnight Financing Rate (SOFR), a contender many financial experts are backing for its perceived accuracy and robustness as a pricing benchmark.
Exploring the Legacy of LIBOR and Its Global Influence
LIBOR was a beacon for loan issuers worldwide, providing a dynamic benchmark for the interest rates on an assortment of financial products. This daily rate was determined by gathering estimates from a panel of up to 18 global banks, each projecting the interest they would charge for different loan durations, in accordance with their view of local economic conditions.
The reach of LIBOR was extensive, influencing the pricing of adjustable-rate mortgages, asset-backed securities, municipal bonds, credit default swaps, private student loans, and various other debt forms. By the close of 2019, LIBOR had played its part in pricing $1.2 trillion worth of residential mortgage loans and $1.3 trillion of consumer loans.
Applying for a loan based on LIBOR involved a financial firm utilizing the LIBOR rate and appending an additional percentage. For instance, in a private student loan application, the loan issuer might take the LIBOR three-month rate and add a premium of 2%. The resultant base rate for the loan, plus other factors like the applicant’s credit score, income, and loan term, would determine the interest charged.
While LIBOR will no longer price new loans, it will linger until at least 2023. Some LIBOR rates have already stopped being published, while others, like the overnight, 1-month, 3-month, 6-month, and 12-month maturities, will be maintained till mid-2023.
The LIBOR Narrative: Scandals and the 2008 Financial Crisis
The phasing out of LIBOR has roots in its role in magnifying the 2008 financial crisis and scandals involving the manipulation of rates by the rate-setting banks.
In 2012, an exhaustive probe into LIBOR’s operation unearthed a complex, far-reaching scheme by several banks to exploit LIBOR rates for their profit. These revelations seriously undermined LIBOR’s credibility, leading national regulators worldwide to explore alternatives.
Transitioning from LIBOR to SOFR: A New Era in Financial Benchmarking
Changes in how banks conduct business and the resultant unreliability of the LIBOR rate necessitated a more reliable benchmark. In the United States, that alternative has emerged as SOFR. This new benchmark focuses on the rates at which U.S. financial institutions lend to each other overnight.
In essence, SOFR encompasses the weighted averages of the rates charged in repo transactions, wherein banks fulfil their liquidity and reserve requirements using Treasury bonds as collateral.
We hope you found this article insightful as you navigate the evolving financial landscape. If you enjoyed learning about LIBOR and its successor, SOFR, you might be interested in our previous analysis of another pivotal financial indicator. Explore our post, ‘Decoding the FTSE 100: Essential Insights for New Investors,’ for a comprehensive breakdown of one of the world’s most significant stock market indexes.