From 31 December 2021, LIBOR will no longer be used. Instead, it will be replaced by SOFR or Secured Overnight Funding Rate. So, what is LIBOR, and what is its significance?
From the perspective of the IAS Exam, it is an essential topic as it deals with setting the interest rates for loans and mortgages across the world.
The topic has a high probability of being asked as a Current Affairs Question in IAS Prelims. Visit the attached link to attempt practice quizzes on current affairs.
Let’s take a look at the details of LIBOR.
The candidates can go through the relevant topics useful for their upcoming exams from the links provided below:
What is LIBOR?
LIBOR’s full form is London Inter-Bank Offered Rate. LIBOR is a benchmark for loan issuers who wish to set interest rates for various financial products. Every day, 18 global banks participated in setting this value.
This benchmark interest rate was calculated in 5 currencies:
- UK Pound Sterling
- Swiss Franc
- Japanese Yen
- US dollar
Banks used LIBOR to price the following products:
- Asset-backed securities
- Municipal bonds
- Adjustable-rate mortgages
- Private student loans
- Credit default swaps
How does LIBOR Work?
Whenever any person applies for a loan, banks would take the LIBOR rate and add an additional percentage depending on the credit score, loan term and income. LIBOR will no longer be applicable to price new loans starting 2022. However, it will stay around till 2023 during the phase-out period.
At first, authorities will not publish the one-week and two-month LIBOR immediately. Then, however, they will publish the overnight, 1-month, 3-month, 6-month, and 12-month rates until June 2023.
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How to Calculate LIBOR?
- Every day, 18 international banks set their idea of how much interest they would pay on the interbank lending market. An average of these values is applicable after stripping out the four highest and the four lowest values.
- Note that LIBOR isn’t the actual rate at which banks lend money. It is their estimate on what they think they should pay. Therefore, it is possible to banks to submit lower interest rates and manipulate the value of LIBOR.
- Many scandals surrounding LIBOR has led the national regulators to look for an alternative.
Scandal Around LIBOR
- The manipulation of LIBOR led to the financial crisis of 2007-2008 when the housing markets crashed in America.
- In 2012, when an investigation into LIBOR started, it came into light that many banks, including Barclays, Deutsche Bank, Royal Bank of Scotland and UBS, manipulated the LIBOR rates for the bank’s profit.
- Barclays was the chief scammer since it submitted lower interest rates giving the impression it was financially secure.
- To counteract LIBOR’s scandals, SOFR will be the primary replacement in the United States. It represents the rate US institutions pay each other for overnight loans.
- Therefore, to conclude, 2021 signifies the end of LIBOR.
Students preparing for the IAS Exam can refer to the latest news reports to increase their knowledge on this topic.
This topic is important for GS Paper-3 and the prelims exam of UPSC 2022.
Frequently Asked Questions about LIBOR
How many residential loans have authorities priced using LIBOR?
As of 2019, authorities have priced around 1.2 trillion dollar residential loans using LIBOR.
How many customer loans have authorities priced using LIBOR?
As of 2019, authorities have priced around 1.3 trillion dollar of consumer loans using LIBOR.
For how many years was LIBOR active?
LIBOR was active for 52 years.
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