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July 12, 2012

What is LIBOR

London interbank offered rate, or Libor, which is the interest rate at which banks are ready to lend to other banks. This rate is used as an international benchmark to set interest rates worldwide for loans to businesses for their working capital needs, or to consumers to buy cars and homes or for settling their credit card debts. In the US, it is even used to compute student loan interest rates. In other words, it is the rate believed to be set by that mysterious oracle in which we have all come to believe: “the market”.

Now it turns out that this oracle, “the market”, which we have all been enjoined to trust and believe in, is in reality fixed by a trade association in London called the British Bankers’ Association. Every day, these banks, 14 in all, tell this association at what interest rate they “could have” borrowed money from each other. The average of these rates is then published as Libor, which is then used by the whole world to set the interest rates on their loans — worth $10 trillion in all.

What everyone, or at least the lay public, has missed is that Libor is not the actual rate at which these banks borrow from each other, but a guess at what they “could have”. This delicate difference allowed those 14 banks to submit almost any number it chose as its borrowing rate. Emails unearthed during the investigation show that Barclays stated rates that would profit the trades it was doing. Stripped of arcane language, it means that the interest rate that Libor sets is a piece of fiction written by these participating banks to suit their purpose.

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