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LIBOR: the world's most important number

LIBOR – the London Interbank Offered Rate - directly affects the cost of borrowing, from company loans to mortgages and overdrafts. Yet surprisingly few investors know what it is...

"The British Bankers Association's London Interbank Offered Rate matters more than any other set of numbers in the world," says Donald MacKenzie in the London Review of Books. That's because it directly affects the cost of vast quantities of borrowing, from company loans to mortgages and overdrafts. Yet surprisingly few investors know what it is.

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Take two banks. Bank A receives £70m of deposits but wants to lend out £100m to earn a higher rate of interest. That leaves it £30m "short". So Bank A calls Bank B, which offers to lend £30m at Bank B's "offered rate". This will vary the three-month rate will not the same as the six-month rate, for example. There may also be a better set of rates available from banks C, D, E and so on, with Bank A free to choose the most competitive.

What the British Bankers Association (BBA) then does every day is to collate and publish an official "sterling interbank offered rate" for loans by contacting individual banks 16 in the case of "sterling LIBOR" asking each for a rate and then working out an average. This is repeated both for different loan terms (so there is a "3m LIBOR" and a "6m LIBOR") and for different currencies, giving rise to a "3m dollar LIBOR" rate, for example. In all the association publishes around 150 different LIBOR rates.

LIBOR is a key rate because it indicates the willingness of UK banks to lend to each other if Bank B doesn't trust Bank A to repay the £30m, it will hike the "offered rate". And if Bank B makes borrowing more expensive for a highly rated competitor such as Bank A, then it will make loans even more expensive for riskier corporate and individual borrowers.

This is the main reason why, when the Bank of England cuts the base rate, floating mortgage rates, linked to LIBOR, may not fall by the same amount unless banks choose to match the cut.

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