Many factors influence the interest rate of a loan. The two greatest factors are the probability of the borrower paying back the loan; and, the “cost” of the money to the lender. As a rational entity, the lender aims to maximize its gain on its assets. When the lender makes a loan to a borrower, it reviews the current market price for money (interest rate). There are various benchmarks used by lenders to determine the market value of loaned money. This memorandum will discuss the London InterBank Offering Rate (LIBOR), one of the most widely used benchmarks, and how it affects our economy.
What is the Libor?
The LIBOR is a widely used measure of the current market price ...view middle of the document...
S. dollars from another bank. Thompson Reuters calculates the average interest rate after excluding the four highest and four lowest rates submitted. The rate is published each day at 12:00 pm.
Why Do We Care About The Libor?
Banks generate revenue by lending money. Prior to making a loan to a customer, a bank will determine the benefit of making that loan compared to loaning money to another financial institution. When a bank makes a fixed interest rate loan to a customer, it is exposed to the risk of interest rate fluctuations. The interest rate between banks (e.g. the LIBOR) may increase to a point that the bank is making less money with the fixed interest rate loan than it would have made by making an interbank loan. The bank accounts for this risk by charging the customer a higher interest rate than the interbank rate.
Adjustable rate loans are one way for banks to shift some risk to the borrower. Banks negate the risk of interest rates rising after making the loan by using adjustable rate loans and linking the interest rate to an index like the LIBOR. Adjustable interest rates are typically lower than fixed rates because more risk is borne by the borrower. If interest rates rise, then the borrower’s payments rise. The LIBOR is a major interest rate index for adjustable rate mortgages in the U.S. The Federal Reserve Bank of Cleveland reported that 47% of adjustable rate mortgages in the U.S. are indexed to the LIBOR. The use of the LIBOR, however, is not restricted to adjustable rate mortgages.
LIBOR serves as the basis for establishing borrowing rates on financial products such as business loans, student loans, credit cards, auto loans and many types of derivative transactions. Nearly half of all student loan lenders, including Sallie Mae, offer variable rate loans based on LIBOR (New, 2012). Estimates vary, but as much as $10 trillion of consumer loans and upwards of $600 trillion of derivatives contracts are tied to the LIBOR (Hopkins, 2012).
The rates paid by consumer borrowers in the marketplace move up and down in accordance with the movement of LIBOR. When LIBOR goes up, so does the bank’s cost of borrowing, and this is passed along to the consumer in the form of higher interest rates (Tynan, 2012). This is evident in looking at LIBOR’s effect on savings account rates. As the cost of borrowing increases, a bank may offer higher savings account rates in order to retain more cash. There are other factors which also affect savings rates, but a decrease in LIBOR, all other things equal, would accompany falling rates on savings accounts, and vice-versa (Tynan).
Municipalities and states are impacted by the LIBOR rate as a result of their increasing involvement in derivative transactions, most notably interest rate swaps. After issuing fixed rate bonds, these entities often “swap” the fixed payment for a variable rate stream. When interest rates drop, these communities’ budgets are strained, leading to layoffs and...