LIBOR

Recent one of the big financial news stories has been about the manipulation of LIBOR. If you have not done business internationally you may not know what it means or how it may be used or have affected procurement or contracts. LIBOR stands for London Inter Bank Offer Rate, which is the interest rate that banks would charge their best customers (which they feel are other banks) based upon their cost of money. Their cost of money is the interest rates that those banks pay their customers or their cost to borrow from other banks. The LIBOR is then used as the basis for determining interest rates charged their customers who will pay incremental percentages above the LIBOR rate based upon their credit and risks with the loan. It the banks artificially kept the LIBOR rate higher than it should be, the banks would make higher profits on the interest from the loans because of the difference between the loan interest rates they charge and the interest rate they pay their customers or other sources of capital. Since banking is international in scope, the LIBOR rate is one of the factors that other locations take into account in setting their rates. For example the Prime Lending Rate in the U.S. takes into account a number of factors including the LIBOR rate.

If illegal manipulation of the LIBOR rate is proven, it has the potential of having a major impact in many areas. For example, in negotiating the cost of a project, the financing costs will have been based on rates that were tied back to LIBOR or the prime rate. Contract’s terms for things like late payments are frequently tied back to a percentage over and above these quoted rates. Costs of purchases by buyers
may have been inflated to cover incremental supplier costs of borrowing money. Homeowners with mortgages that are adjustable based on changes to these rates will have paid more.

While I prefer to establish fixed rates in contracts, using published rates is sometimes needed. I approach them with caution. Rather than rely only on one, I may try to establish a blended rate. The goal of a blended rate is to minimize any impact of one of the individual rates being manipulated. I don’t always trust a single published rate based on my experience. In one of my jobs I was responsible for managing the procurement aspects in starting up new operations in countries where we didn’t have a presence. I would do the recruiting and hiring of personnel and manage their training and would manage the procurement of the facilities, and much of the locally available equipment and suppliers needed. One of these activities was the start up of a new plant in Brasil during a period in which the country was having hyper-inflation. When I say hyper- inflation I mean the inflation rate would increase 3% or more a day! This meant price was subject to adjustment based upon when the payment was made and how much inflation had occurred from the date the contract was signed to when payment was made. The challenge was which rate should I use. The government published an inflation rate that was considered by most to be lower than the actual rate of inflation. A contractor’s organization published an inflation rate that was traditionally considered higher than the rate of inflation. There was another rate based upon changes in the exchange rate between the Brazilian currency and the American Dollar. The problem was at the time Brazil had two different currency exchange rates. There was the official rate that banks would exchange money based on what the government told them the exchange rate was as the currency was controlled. There was also a “parallel” rate at which individuals and business would buy dollars at as a hedge against inflation. While it was a form of black market currency exchange, the parallel rate was published in all the papers and the changes in it reflected the inflation that was occurring as a result of the devaluation of the currency by inflation. The simplest thing would have been to have U.S. dollar based contracts, but by law you could not pay the Brazilian companies in U.S. dollars. So you needed to either use a rate to calculate the inflation.

I worked with our local finance people to come up with a formula that used all three rates to establish a blended rate that they felt would provide us with a fair result for us and the contractors and suppliers. We knew that if we used just the government rate, the contractors would have included significant contingencies for inflation in their price. We also knew that if we only used the contractor’s association rate we would have paid more that the actual inflation. By blending the three we sought to eliminate any contingencies for inflation. It was the only contract that I’ve ever written where the final monthly invoices and payments were more than the original contract price!