LIBOR is one of the most widely used benchmarks for determining short term interest rates across world. Administered by the ICE Benchmark Administration (IBA), it stands for Intercontinental Exchange London Interbank Offered Rate. It indicates the average rate at which large banks in London can borrow unsecured short term loans from other banks. The rate is given in five major currencies for seven different maturities, the three month US dollar rate being the most common. (For more, refer to How Is LIBOR Determined and London Interbank Offered Rate)
Uses of LIBOR
Lenders, including banks and other financial institutions, use LIBOR as the benchmark reference for determining interest rate for various debt instruments. It is also used as a benchmark rate for mortgages, corporate loans, government bonds, credit cards, student loans in various countries. Apart from debt instruments, LIBOR is also used for other financial products like derivatives including interest rate swaps or currency swaps.
For example, a US dollar denominated corporate bond, with quarterly coupon payment, may have a floating interest rate as LIBOR plus a margin of thirty basis points (1%=100 basis points). The interest rate thus would be three months US Dollar LIBOR plus the predetermined spread of thirty basis points, i.e. if the 3 month US Dollar LIBOR at the beginning of the period is 4%, the interest to be paid at the end of the quarter would be 4.30% (4% plus 30 basis point spread). This rate would be reset every quarter to match with the existing LIBOR at that point in time plus the fixed spread. The spread is generally the function of the credit worthiness of the issuing bank or institution. (For more refer to What Is ICE LIBOR and What Is It Used for?)
The very concept of issuing a floating rate debt instrument is to hedge against the interest rate exposure. If it is a fixed interest rate bond, the borrower will benefit if the market interest rate rises and the lender will benefit if the market interest rate falls. In order to protect themselves from this fluctuation in the market interest rates, the parties to the debt instrument use a floating rate determined by a benchmark base rate plus a fixed spread. This benchmark can be any rate; however, LIBOR is one of the most commonly used ones.
It makes sense for a large bank in London to lend at a floating rate linked to LIBOR since most of its borrowing would be from other banks in London, ie. matching the risk of the asset (loans given) with the risk of its liabilities (i.e. borrowings from other banks). However, in reality the major source of funds for a bank is the deposits it receives from its customer and not from borrowing from other banks. However, linking it to LIBOR is a way of passing the risk to the borrowers.
In simplistic terms, banks make money by accepting deposits at one rate and lending at a higher rate. If the cost of funding for the bank rises, say because of some change in government regulations, liquidity requirement, etc with the market interest rate remaining constant, the LIBOR will rise. With the rise in LIBOR the interest received from the LIBOR linked floating rate lending will rise too i.e. the bank can continue to make money in spite of rise in cost.
But that still doesn’t answer the question, why would LIBOR be used in other contexts like credit card loans in the US. There are multiple reasons for the same; however, one of the primary reasons includes LIBOR’s worldwide acceptability.
The origin of the LIBOR is specifically rooted in the explosion of the Eurodollar market (US dollar denominated bank deposit liabilities held in foreign banks or foreign branches of US banks) in the 1970s. US banks resorted to Eurodollar markets (primarily in London) for protecting their earnings by avoiding the restrictive capital controls in the US at that time. LIBOR was developed in 1980s to facilitate syndicated debt transactions. Growth in new financial instruments also requiring standardized interest rate benchmarks, led to further development of LIBOR.
Determination of LIBOR is widely perceived to be a simple, objective and transparent process which has helped it gain global acceptability and significance. Continuing with the reasoning of protecting from interest rate risk, LIBOR is viewed as a uniform and fair benchmark which creates a sense of certainty. However, with the LIBOR manipulation cases reported in recent times, the certainty can be argued to be more a matter of perception than hard reality. (For more refer to 'The LIBOR Scandal')
Convention is another primary reason for the extensive use of LIBOR as a benchmark reference rate.
The Bottom Line
LIBOR is referenced by an estimated US$ 350 trillion of outstanding business in different maturities. (ref - https://www.theice.com/publicdocs/ICE_LIBOR_Position_Paper.pdf ) It is also often used in building expectations the future central bank rates as well as for gauging the health of the banking system in the world. Because of its global significance and reach, a downward pressure on LIBOR during financial crisis as banks try to appear healthier, can potentially risk the entire global financial system.