Why are Your Interest Rates Changing Forever?!
What is LIBOR, how is LIBOR, why is LIBOR? The big bankers of the world have manipulated LIBOR into eradication. What's taking its place?
LIBOR, one of the world’s most important numbers, is now being phased out.
LIBOR (London Interbank Offered Rate) determines interest rates for the world. Everything from your credit card and car loans to complex financial instruments is influenced by the LIBOR rates.
But now, it is set to be scrapped from the world by June 2023. And for India, it is set to be replaced from December 2021.
We know what you're thinking…
It really sounds like a big change. But what is LIBOR after all? And if it is so important, why is it being scrapped?
LIBOR: Why and How?
The story dates back to 1969. Iran’s ruler Riza Shah needed $80 million for his government. Now, no single bank or institution was so powerful or wealthy to arrange that kind of money. So they contacted a very resourceful and innovative banker, London’s Minos Zombanakis, to find a solution and arrange funds.
First, Zombanakis convinced a syndicate of banks to collectively arrange the loan. This way, the risk of any single institution would be significantly reduced. But, then came the question - "at what rate will banks lend this amount?"
The amount of loan was huge, and it was for a long time. In such a case, having a fixed interest rate for banks was a very risky proposition.
Why risky?
Because that’s how banks earn. They borrow at a lower rate and lend at a higher rate. Their profit lies in margins. Now, money is borrowed from the central banks (like India has RBI), other banks, and the public in general. But these rates keep on changing. As long as this rate is lower than the fixed interest rate at which banks have given loans, all is good. However, if this rate goes higher than that, banks will have to bear a loss. A loss that could very well extend to millions of dollars.
Well, the banks had not faced such a peculiar problem in the past, because globalisation had just started making headway. But now, things were changing, and London was at the centre of it all.
So, how did they solve the interest rate problem?
Zombanakis had an idea. Why not just use a flexible interest rate? The banks could simply report their cost of borrowings at a defined interval. An average of all these costs plus a markup (profit) could then be charged to Shah.
Everyone was happy with this arrangement and the technique soon became the backbone of the financial world. How?
The Zombanakis' way soon evolved into a benchmark rate for short-term loans for the world. That came to be known as LIBOR.
How is LIBOR calculated?
18 major banks submit their cost estimates for the day. The highest and the lowest rate is left out from the calculation. The average rate of the remaining 16 banks becomes the LIBOR rate. And, it isn’t just one rate. Around 35 rates were reported in the morning every day.
Things look ingenious, except that the process had a major flaw.
LIBOR used ‘estimated’ borrowing rates as the base. And, anything that is estimated is also one day manipulated. Human nature, duh! (tweet this).
Some of the submitting banks started colluding to report a lower rate of borrowings. These record-low rates showed the strength of the banking world and were one of the reasons for the 2008 crisis.
The banks were basically, themselves laying down the tracks that they intended to run on. Having knowledge of the interest rate they planned to rig allowed them to get into profitable contracts with that foresight.
After the 2008 crisis unfolded, regulators started snooping around. The scam came to light in 2012 and banks were levied with fines totalling $9 billion.
This expose on the unreliability of LIBOR has become one of the reasons to phase it out.
If not LIBOR, then what?
The world is on the lookout for an alternative benchmark. One such benchmark that is being used in the United States is the Secured Overnight Financing Rate (SOFR). Unlike LIBOR, SOFR uses rates based on actual observed borrowing transactions by the banks.
Some Indian banks have also started using SOFR. But they are still on the lookout for an alternative benchmark.
But, why set such distant transition deadlines when the scam was unearthed in 2012?
Because transactions to the tune of $331 billion (In India) drawn in terms of LIBOR rates are set to continue beyond 2021. How these transactions will be impacted needs to be seen. It’s a big change that cannot be implemented just like that.
The way your interest rates are determined is going to evolve. And now you know why.
To read further on the LIBOR scandal check out this amazing book ‘The Spider Network: The Wild Story of a Maths Genius, a Gang of Backstabbing Bankers, and One of the Greatest Scams in Financial History’