Libor Rate History Compared to Fed Funds Rate

Libor is the interest rate banks charge each other for short-term loans. Historically, the Libor rate is usually a few tenths of a point above the federal funds rate. When it diverged from the fed funds rate in September 2007, it was among the financial indicators foreshadowing the financial crisis of 2008.

Libor is short for the London Interbank Offered Rate. Originally, London banks in the British Banking Association (BBA) published it as a benchmark for global bank rates. In February 2014, after the BBA was found guilty of price-fixing, the Intercontinental Exchange (ICE) took over its administration. The rate-fixing inquiry revealed how banks manipulated interest rates for their own gain.

Historical Libor Interest Rates

The table and chart below show a snapshot of the historical Libor rates compared to the fed funds rate since 1986. Pay particular attention to the Libor rates from 2007–2009, when it diverged from the fed funds rate.

In April 2008, the three-month Libor rose to 2.9%, even as the Federal Reserve lowered the fed funds rate to 2%. That was after the Fed had aggressively dropped the rate six times in the previous seven months. After 2010, Libor steadily declined to be closer to the fed funds rate. From 2010 to 2014, the Fed used quantitative easing to keep rates low. It bought U.S. Treasury notes and mortgage-backed securities from its member banks.

Why did Libor suddenly diverge from the Fed's interest rate target? It's because banks started to panic when the Fed bailed out Bear Stearns, which was going bankrupt due to investments in subprime mortgages. Throughout the spring and summer, bankers became more hesitant to lend to each other. They were afraid of the collateral that included subprime mortgages. Libor rose steadily to indicate the higher cost of borrowing.

On October 8, 2008, the Fed dropped the fed funds rate to 1.5%. Libor rose to a high of 4.8% on October 10. By the end of the month, the Dow had fallen 16%.

By the end of 2009, Libor returned to more normal levels thanks to Federal Reserve measures to restore liquidity. 

Since 2010, Libor has steadily declined to be closer to the fed funds rate. From 2010 to 2014, the Fed used quantitative easing to keep rates low. It bought U.S. Treasury notes and mortgage-backed securities from its member banks.

In the September of 2011, the Fed implemented Operation Twist, another form of quantitative easing. Despite this easing, the Libor rate rose in late 2011. Investors grew concerned about potential debt defaults from Greece and other contributors to the eurozone debt crisis.

In late 2015, Libor began rising again. Investors anticipated that the Federal Open Market Committee would increase the fed funds rate in December. The same thing happened in 2016. 

Source: "Historical Fed Funds Rate," Federal Reserve. "Historical Libor Rate," Federal Reserve.

Early History

In the 1980s, banks and hedge funds began trading options based on loans. The derivative contracts promised high returns. There was just one hitch. Both parties had to agree on the interest rates of the underlying loans. They needed a standard method to determine what a bank would charge for a future loan.

That's when the British Banking Association stepped in. In 1984, it created a panel of banks. It asked them what interest rate they would charge for various loan lengths in different currencies. Banks could now use the results to price derivatives.

The actual survey question was, "At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11 a.m.?"

On September 2, 1985, the BBA published the predecessor to Libor. It was called BBAIRS, short for the British Bankers Association Interest Rate Swap. In January 1986, it released the first Libor rates for three currencies: the U.S. dollar, the British sterling, and the Japanese yen.

The BBA responded to the 2008 financial crisis by modifying its survey question. It asked panel members: "At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?" The question was more realistic. It gave better results by asking the bank what it could actually do, rather than what it thought.