LIBOR, London Interbank Offered Rate, is the interest rate that banks use to lend money to other banks globally, similar to how the Federal Funds Rate is used for US banks, but on a multinational scale. To cover reserve requirements, banks may need to temporarily borrow funds from other banks. Conversely, when banks have an excess of cash, they want to lend that money out to make a profit. LIBOR is the base rate that is used for that funding and as such, it’s recognized as an international standard. At least it was until recently.

The earliest beginnings of LIBOR can be traced back to a Greek banker by the name of Minos Zombanakis, who back in 1969 arranged an $80 million syndicated loan from Manufacturers Hanover to the Shah of Iran based on the reported funding costs of a set of reference banks. The British Bankers’ Association formalized the rate in 1986 and surveyed international banks at their London offices.

Setting the LIBOR is currently done by the Intercontinental Exchange (ICE), an American company based in Atlanta. ICE houses financial and commodity marketplaces and exchanges by asking major global banks, “at what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am?” In other words, the question to the banks is basically “what would your bank charge other banks for a short-term loan?” Then those answers are averaged.

Other industries would then use the LIBOR and add whatever spread was applicable to cover their specific risks. Our Dunn Capital Partners group uses LIBOR (and now SOFR which we’ll get to in just a minute) to price existing debt on deals or for short bridge loans, anytime a mutually recognized standard source is needed as a common reference rate for financing. It’s a key component of the pro forma on many projects and because it fluctuates and adjusts, it brings an added layer of uncertainty and complexity. That uncertainty gets managed by looking to rate curves and forecasting expectations.

Because the rate was set by taking the average of what banks decided their own rate would be, the opportunity for collusion was always a weakness of LIBOR. In addition to the incentive for banks to underreport funding costs, the rates for Credit Default Swaps (as seen on The Big Short), the abuse of which partially led to the 2008 financial crisis, were set using LIBOR, while that same rate was used for interbank loans. When the CDS loans proved riskier than initially accounted for, it led to more banks requiring loans while simultaneously making them more reluctant to lend to other banks, perpetuating and transmitting the vicious cycle across the globe.

With LIBOR being seen as a less reliable benchmark, a new standard was needed. Global regulators have since suggested the use of SOFR, the Secured Overnight Financing Rate. SOFR is based on actual overnight transactions in the US Treasury repurchase market, reflecting the cost of borrowing cash overnight collateralized by Treasury securities. As such, it’s considered a more robust benchmark, with a deeper and more active market, and less prone to manipulation (fingers crossed).