Libor is determined each day in London by more than 15 major international banks, including HSBC, Deutsche Bank, J.P. Morgan, Barclays and Bank of America.
How it works
Every morning the banks submit offers to the Intercontinental Exchange Benchmark Administration for rates they would pay to borrow from the others. The highest and lowest offers are eliminated, and an average rate is calculated from the rest.
Libor rates reflect the level of confidence in economies and banking institutions. When Libor inches higher, it mirrors banks' concern about the health of their fellow institutions.
But a low Libor isn't necessarily a positive sign: Some of the chaos surrounding the 2008 financial crisis had roots in an intentional skewing of the rate. Banks have paid billions in fines and penalties for manipulating Libor.
Because of those shenanigans, regulators are phasing out Libor and plan to replace it with a new benchmark rate by 2021.
How Libor affects you
But for now, Libor rules. In the U.S., interest rates on adjustable-rate mortgages and student loans are tied to Libor. It's an example of how global financial markets impact everyday living costs across the world.
At one time, the banking system was more local. A bank in your area would invest its assets by lending to consumers and businesses in the community. But bankers eventually realized that keeping all assets and liabilities in-house carried too much risk.
As a result, Wall Street encouraged banks to sell off loans to institutional investors. The earliest of these investors were familiar with Libor, so they used it as an index for pricing the loans on the secondary market.
Since interest rates reflect and contribute to overall economic health, it's important to understand their origins and impacts.
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