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The London Interbank Offered Rate, commonly known as Libor, is a measure of the interest rates that banks charge one another to borrow money on a short term basis. This serves as a standardized reference point for tracking the availability of credit to financial institutions and ultimately to customers. The rate is also used as the basis of some specific investment products.
The need for interbank lending comes from the fact that different banks will have differing cashflows from day to day, simply because one some days a bank will take more deposits than it advances in loans and withdrawals, and on some days, it will be the other way around. It would be impractical to keep enough cash on hand permanently to deal with these fluctuations because, although they may be small in percentage terms, they can add up to huge amounts. To get around this, banks lend and borrow money to one another on what are known as interbank or wholesale money markets. In some cases, these loans can be for as little as one day.
Although each bank will be offering interbank loans at differing rates at any particular time, those involved in finance need a quick way to get an overall picture of the market. This is supplied on the London markets in the form of the London Interbank Offered Rate. The rate is calculated by Thomson Reuters, although this is on behalf of the British Bankers Association. It is purely a guideline and there won't necessarily be any loans available at that specific rate. There is a separate rate for loans offered in each individual currency.
To calculate the London Interbank Offered Rate, Thomson Reuters takes the rates offered at 11 a.m. London time from a set number of banks, which varies depending on the currency. It then discards the highest 25 percent of rates and the lowest 25 percent of rates; this will be the highest and lowest one, two, or three rates, depending on the currency. The remaining rates are added up and divided by the number of remaining rates to produce the rate. This technique is known as the interquartile mean.
In theory, the London Interbank Offered Rate is an indicator of the availability of credit. Usually, a higher rate means banks are more wary about lending to other banks and, in turn, less able to borrow affordably. In turn, a higher rate will usually mean banks wind up less willing or less able to lend to the public, which makes business and consumer credit either harder to come by, more expensive, or both.