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Wednesday, July 4, 2012

Interest rate scandal explained

NEW YORK (CNNMoney) -- Banking giant Barclays Capital has been rocked this past week by revelations that it manipulated Libor, a key benchmark for interest rates worldwide, for its own benefit. CEO Bob Diamond has resigned, and the scandal appears set to spread to other banks as well. But just what is Libor, and what's this whole controversy about?

What is Libor? Libor is short for the London Interbank Offered Rate, a measure of the cost of borrowing between banks and a crucial benchmark for interest rates worldwide. It's actually a collection of rates generated for 10 currencies across 15 different time periods, ranging from one day to one year.

Libor rates are set each business day through a process overseen by the British Bankers' Association.

Between seven and 18 large banks are asked what interest rate they would have to pay to borrow money for a certain period of time and in a certain currency. The responses are collected by Thomson Reuters, which removes a certain percentage of the highest and lowest figures before calculating the averages and creating the Libor quotes.

Interbank rates are measured elsewhere in the world through similar processes. For example, there's also Japan's Tokyo Interbank Offered Rate, or Tibor, and the Belgium-based Euro Interbank Offered Rate, or Euribor.

How does it affect consumers? Libor is the world's most important benchmark for interest rates. Roughly $10 trillion in loans -- including credit card rates, car loans, student loans and adjustable-rate mortgages -- as well as some $350 trillion in derivatives are tied to Libor.

If Libor goes up, your monthly interest rate payments may go up with it. If it goes down, some borrowers will enjoy lower interest rates, but mutual funds and pensions with investments in Libor-based securities will earn less in interest. Read More