What Is the Difference Between Libor & Prime Interest Rates?

The Libor scandal has rocked the credibility of the once-trusted rate.
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When you arrange credit, your thoughts naturally turn to how much interest you’ll be coughing up to the bank or other lender. Lenders determine their interest rates using a well-known index, such as the prime rate or the London Interbank Offered Rate. Though their basic purpose is the same, the two rates differ in their preparation, audience and honesty.

1 The Prime Rate

American banks and other lending institutions charge the prime rate to their best customers for short- and medium-term loans. The prime rate is loosely based on the federal funds rate, set by the Federal Open Market Committee of the Federal Reserve every six weeks. When setting the rate, the committee considers inflation and economic activity. Banks start with the fed funds fate and add a spread of about 3 percent to arrive at the prime rate. The Wall Street Journal is the acknowledged guardian of the prime rate, which it bases on the best rates charged by the largest 10 American banks. When seven of these banks change their rates, The Journal updates its WSJ Prime Rate. Use of the prime rate is almost exclusive to the United States.

2 London Interbank Offered Rate

The 18 members of the British Bankers' Association secretly forward their current rates to Thomson Reuters every business day before 11 a.m London time. Reuters uses the information to calculate 150 rates that carry the Libor brand name. Reuters publishes the updated rates by noon. Libor is actually a collection of rates for 10 currencies and 15 borrowing periods, from overnight to one year. Banks around the world borrow from each other at the Libor, and many consumer and commercial loans are derived from Libor plus a spread.

3 Audience

A banking cartel sets Libor primarily to govern interbank lending rates. It thus resembles the fed funds rate, which is the overnight rate at which banks can borrow from each other, rather than the prime rate. The prime rate doesn’t play a regulatory role. Rather, it is the best deal available to the largest corporate and institutional customers of American banks. Changes in either rate can have enormous impact. Some Libor rates change daily, whereas the prime rate is tied to the fed funds rate, which normally is set for six weeks at a time. For this reason, markets that deal with very short-term debt are more likely to rely on the Libor than on the prime rate.

4 Ethics

The minutes of rate-setting meetings of the Federal Open Market Committee, the indirect source of the prime rate, are published and available for inspection by Congress and the public. On April 10, 2013, Bloomberg reported that the minutes were released early to certain banks and members of Congress. The committee said that was an accident. The workings of the British Bankers' Association are opaque and, as it turns out, not above board. A Libor scandal began in 2008 when The Wall Street Journal exposed market manipulation and rate fixing. In December 2012, banking giant UBS agreed to pay $1.5 billion for its role in the deception. The fraud caused consumers to overpay for credit, and cities lost money on Libor-related investments. In September 2012, the British Bankers' Association agreed to oversight by the UK regulators.

Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.