The first sign was in April 2008, when the 3-month LIBOR rose to 2.9% even as the Federal Reserve lowered the Fed funds rate to 2%. This was after the Fed had already aggressively dropped the rate six times in the previous seven months. (For details, see Current Fed Funds Rate.
Why did LIBOR suddenly diverge from the Fed's interest rate target? Banks started to panic when the Fed had to bail 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, reacting to fears they would inherit each others' subprime mortgages as collateral or would not get paid back on their loans. LIBOR rose steadily to indicate the higher cost of borrowing. On October 8, 2008, the Fed dropped the Fed Funds rate to 1.5%, but LIBOR continued rising to a high of 4.8% on October 13. In response, the Dow dropped 14% in October. Since then, LIBOR has steadily declined to more closely match the Fed Funds rate.
What Are the Historical LIBOR Interest Rates
Here are the historical LIBOR rates compared to changes in the Fed Funds rate since 2006. It shows how LIBOR diverged slightly in the fall of 2007, and then really diverged in the Spring of 2008. It returned to more normal levels by the end of 2009 in response to Federal Reserve measures to restore liquidity. These programs included and In 2010 and 2011, the Fed kept interest rates low with quantitative easing by buying U.S. Treasury notes and mortgage-backed securities. In the summer of 2011, the Fed announced Operation Twist, another form of quantitative easing. Despite this easing, the LIBOR rate rose in late 2011 as investors grew concerned about potential debt defaults from Greece and other contributors to the eurozone debt crisis.Early History of LIBOR
In the early 1980s, banks and hedge funds began trading more and more options based on loans. They needed a standard method to determine what a bank would charge for a loan in the future. These derivatives promised higher returns for the banks, but they were difficult to negotiate the contract until both parties agreed on what the interest rate would be.That's when the British Banking Association stepped in. In 1984, it created a panel of banks that it would poll on what interest rate they would charge for various loan lengths and various currencies. This poll would be used by all banks to price derivatives. In fact, the actual question posed 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 11am?"
On September 2, 1985, the BBA published the predecessor to LIBOR. The BBAIRS was the Interest Settlement rate. The first LIBOR rate was published in January 1986, in three currencies: the U.S. dollar, the British sterling and the Japanese Yen. Today, the LIBOR rate is given for ten currencies, in fifteen maturities ranging from overnight to 12-month loans.
In addition, BBA has changed the question asked of the panel of banks, in response to the realities of the financial crisis of 2008. Banks are now asked: "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 am?" BBA changed the question because it is more realistic and gives better results to ask a bank what it could actually do, rather than a hypothetical question. (Source: BBA, Historical Perspective)
3-Month LIBOR Compared to Fed Funds Rate Chart
| Date | Fed Funds Rate | 3 MO LIBOR Rate |
| Dec 31 2011 | 0 | .55 |
| Dec 31 2010 | 0 | .30 |
| Dec 18 2009 | 0 | .25 |
| Jun 17 2009 | 0 | .61 |
| Mar 31 2009 | 0 | 1.73 |
| Dec 5 2008 | 1.00 | 2.19 |
| Oct 29 2008 | 1.00 | 3.46 |
| Oct 8 2008 | 1.5 | 4.3 |
| Apr 30 2008 | 2.00 | 2.9 |
| Mar 18 2008 | 2.25 | 2.6 |
| Jan 30 2008 | 3.5 | 3.8 |
| Jan 22 2008 | 3.00 | 3.2 |
| Dec 11 2007 | 4.25 | 5.1 |
| Oct 31 2007 | 4.5 | 4.9 |
| Sep 18 2007 | 4.75 | 5.6 |
| Jun 29 2006 | 5.25 | 5.5 |
| May 10 2006 | 5.00 | 5.2 |
| Mar 28 2006 | 4.75 | 5.00 |
| Jan 31 2006 | 4.5 | 4.7 |
