LIBOR and Student Loans

by Jeff Davis, Business Program Chair, Online Division

You have probably heard about the scandal involving the British bank Barclays and the interest rate called LIBOR (pronounced lie+bor, appropriately enough). Here are answers to some questions you may have.

What is LIBOR?

LIBOR stands for London Interbank Offered Rate. It is used worldwide, including in the U.S., as a benchmark for setting interest rates on many financial products. LIBOR is supposed to represent the interest rate that a bank would have to pay to another bank to borrow money, as determined by a panel of 18 banks. As of today, that rate is 0.46%. A bank loan to an individual will be quoted as LIBOR plus something. For example, you might have a loan with an interest rate given as LIBOR +3%, in which case your interest rate today would be 3.46%.

What is the LIBOR scandal?

There are two separate scandals. First, it has been discovered that traders at large financial institutions have been contacting LIBOR panel banks to get them to manipulate interest rates in the trader’s favor. These traders stand to make or lose millions of dollars a day based on small changes in the LIBOR. As a simplified example, you can imagine that you and I have made a bet about what interest rates are going to be at a certain bank tomorrow, and I cheat on our bet by getting my friend at the bank to set the interest rate that I want. Although investigations are still pending, it appears that dozens of financial institutions have been involved in manipulating rates for many years.

Second, during the financial crisis, LIBOR panel banks were stating rates that were below the actual rate that they are supposed to report. This was to make the banks appear more financially sound. Imagine that you ask me the interest rate at which people are willing to loan me money. If I’m a terrible credit risk, that rate might be, say, 19%. I don’t want you to think that I’m a bad credit risk though, so I lie and tell you that my borrowing rate is 5%. In a similar way, banks who did not want to appear weak during the financial crisis could report borrowing rates lower than reality. (Note, however, that banks were under-reporting by an estimated 0.3% to 0.4%, not the 14% as in this example). These reported borrowing rates are what determine the
LIBOR.

Does the LIBOR scandal affect my student loans?

It’s possible, but if so, minimally, and probably in your favor. Some private lenders do base student loan interest rates on LIBOR. Others base it on the Prime rate or the rate on U.S. Treasury bills. Rates for federal student loans are set by the government and are unrelated to LIBOR. If you do have a loan based on LIBOR, note that in the first part of the scandal described above, interest rates might have been manipulated a small bit up on certain days, but a small bit down on other days. Regarding the second part of the scandal, interest rates were being manipulated only down. The overall effect, if any, is that your borrowing rate may be a bit lower than it should have been. You should still be appalled at how easily banks and large traders can manipulate the financial system in a way that affects millions of ordinary savers and borrowers.

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