What is LIBOR and SOFR in the context of finance?
In: Economics
Imagine you run a big bank. All day in various branches your staff add money to people’s savings accounts, and give loans to people. You need the money that goes out to match the money that comes in, but you can’t count it all in real time. So instead at the end of the working day you count it all up. Imagine you are short: you lent out more money than came in, and so you have negative money on your books.
What you do is, you go to another bank and ask for an overnight loan to make up the shortfall, then tomorrow you will try to give out slightly fewer loans or bring in more cash to get back to even. That other bank is happy to lend you the money because they have extra cash sitting in their account doing nothing, and they know that tomorrow night they might need to borrow some spare cash from you. It’s been a long day, so you and the other bank manager don’t want to spend ages negotiating the interest she is going to charge you on this overnight loan; wouldn’t it be nice if there was some pre-agreed mutually acceptable rate?
The London Inter-Bank Overnight Rate was the agreed interest rate for these short term loans, and its value changed as bank liquidity shifted etc. The problem was that it started as a tool between banks to make their lives easier, but other people started noticing it was a good measure of certain market properties (like the bank liquidity I mentioned). The banks decided among themselves what the LIBOR rate should be at a given moment, and they realised they could make extra money if they artificially moved the rate from its “correct” value. Eventually this was noticed and the whole thing got shut down. Of course banks still need to lend to each other on a short term basis, so equivalents still exist.
LIBOR = London Interbank Offered Rate
SOFR = Secured Overnight Financing Rate
Banks are required to keep a minimum amount of cash available for withdrawal for their customers to avoid a scenario where the bank runs out of cash. The required minimum fluctuates and is a function of the total deposits at the end of a business day. Lets say a bank has $1M in deposits and the regulations state that minimum reserve must be 10%. The the end of the day, the Bank checks to see if they have $100K in reserves. If they have that 100K or more, then no problem, but say that they have only 90K. They have to find that 10K somewhere to meet the requirement. The national bank (e.g. Federal Reserve bank, Bank of England, etc.) can step in and offer short-term loans to banks in order to meet this requirement – however, it is a loan and the bank has to pay interest.
This interest rate that is offered between financial institutions is important because its seen as the baseline of “what it costs to borrow money?”. LIBOR and SOFR are both examples of this rate.
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