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The deadline for replacing LIBOR looms

A MARTINEZ, HOST:

LIBOR is the London Inter-Bank Offered Rate, and it's a pretty important number. It's the building blocks of how the world's banking system operates. For example, it's how interest rates are set on everything from car and student loans to how big corporations get their funding. But at the end of the year, LIBOR will start to be phased out. Mary Childs from our Planet Money podcast team has the story.

MARY CHILDS, BYLINE: Michele Kawiecki is the chief financial officer at a bank in Indiana. And for decades, her bank, First Merchants Bank, would make loans using LIBOR, just like most banks. But now that it's going away...

MICHELE KAWIECKI: It's just like taking a third of your business, and you say, this is what we sell, and here's what the price is. And then you've got to say, Hey, we're going to keep the price the same, but the way that we're going to explain the price has to be rewritten in thousands of documents.

CHILDS: The way LIBOR got to be so everywhere goes back to the 1960s and the Shah of Iran. He needed a loan, a big one. So he asked a banker in London, who, because it's such a big loan, asked his buddies. And they had to figure out how much to charge the shah in interest for his loan. That interest rate needed to reflect how risky they thought the shah was as a borrower. Yesha Yadav, a law professor at Vanderbilt University, says setting an interest rate, getting that number right, is really hard.

YESHA YADAV: You need to work out all these different informational points to figure out exactly how much you should charge for an interest rate to a borrower. Where is the borrower living? What currency, the time - all of these different factors are really, really important in pricing a debt.

CHILDS: So the bankers started with what they knew, how much it would cost to lend to each other. They asked each other and took the average. And they figured lending to each other, a bunch of bankers - pretty safe. The shah seemed riskier, so they would charge him more to reflect that perceived higher risk. Another thing - they agreed to keep in touch. They could change this rate as the economy changed. The rate would adjust. So the shah got his loan, and the bankers got this magical interest rate that made a complicated thing simple. LIBOR was so efficient, everybody started using it.

YADAV: So the ugly side of LIBOR is exactly as you would predict it would be, right? Banks started to misreport how much it cost to borrow funds from another bank.

CHILDS: This all came out, finally, in the wake of the Great Recession. LIBOR was manipulated. Eventually, regulators said, that's it. No more. No new contracts with LIBOR. That deadline is the end of this year. So now in Indiana, Michelle Kawiecki's team basically has three options that all provide a starting point for pricing a loan. There's one put together by Bloomberg, one by the big banks and the New York Federal Reserve and one folksy upstart that Kawiecki's bank actually helped to get started. And all these different options might sound chaotic. But for Kawiecki, that's fine. She didn't expect any of them to be the new LIBOR because there is no new LIBOR.

KAWIECKI: I think each bank needs to be prepared to offer the benchmark rate that their customer wants.

CHILDS: Maybe all using one big rate was risky. Maybe this way will be better. For NPR News, I'm Mary Childs.

(SOUNDBITE OF PETE ROCK'S "A LITTLE SOUL") Transcript provided by NPR, Copyright NPR.