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London InterBank Offer Rate. Created by Sal Khan.

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Video transcript

You might have heard the term LIBOR when people are quoting interest rates. Or they're saying "Hey I'm gonna lend you money a few percentage points above LIBOR" You will hear...LIBOR quoted on some of the financial news channels. And what it is, is just an average of the interest rates that banks are lending to each other. And it is calculated by the British Bank Association. It's actually calcuated by Thomson Reuters for the British Bank Association. But it's there to kind of provide a benchmark for other types of securities and financial transactions. And it literally stands for the London Interbank Offered Rate. So...it's the..... in London...it's the rate..the offered rate between banks. The London Interbank Offered Rate. To understand that a little bit better we have set up two banks over here Bank A and Bank B. And you might have already known that when you go and deposit your money in banks, the bank won't leave all that money around. The way it makes money is lend a good bit of money to other people as loans. And it keeps just enough cash on hand That things well you know, people would actually come and ask for money from their checking account. We have enough on hand You could imagine....every now and then that bank might get low on cash. or it might get close to kind of a reserve requirement that the central bank in that country requires a bank to have on it. So in those situations ...say bank A is getting to that...that situation. They said "let me go borrow some money" Let me go borrow money from another bank. So this is interbank borrowing. Bank B over here they are flushed with cash So they say we don't like to keep so much cash around. We want to lend it. So we can actually get interest. We get no interest on cash So maybe bank B lends money to Bank A So maybe they lend this much cash So that's the new cash that bank A got. Right over there ...the new cash And of course it is a loan So this is a new loan. To offset it, remember assets are equal to liabilities plus equity. So liabilities is this whole thing over here. So this is loan from B for this cash. They have a little bit better of a cushion. And now B, their loan has increased and their cash has decreased. So this is a loan, loan to A. Right now, they took this cash and they gave to bank A And that rate that they lent it at, maybe it was that 1% annual rate. And of course it is to be renewed everyday, it is overnight rate. This rate is an interbank rate. So what they do is on behalf of the British Bank Association They go survey a bunch of banks in London eight, twelve, sixteen banks in London. So they said "Hey what was the rate in which you all transacted" and they will quote that They quote that as the overnight LIBOR So they quoted it, say hey 1.2% across all of the banks that we surveyed But what's interesting about the LIBOR, it is done in ten currencies It is not just in the sterling, the dollar or the yen...It is in ten currencies That's what really differentiate it amongst other things But really differentiate it from the effective Federal Funds Rate which is another interbank borrowing rate But that's in the United States And that's more revolving around policy concerns. The Federal Bank actually tries to change it.