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The LIBOR-OIS spread reveals banks’ confidence in the market
February 4, 2009
The LIBOR index alone tells us many things, namely confidence (or lack thereof) that prominent banks have in the market and expectations for borrowers large and small regarding cost of funds. The LIBOR index juxtaposed with another index can give us an even clearer picture of market stability and direction. OIS—Overnight Indexed Swap—is one such benchmark that runs parallel to LIBOR. Analysts constantly watch the spread between these two (think paparazzi tracking Paris Hilton’s movements) with big gaps receiving big notice.
The LIBOR-OIS Spread compares the 3-month LIBOR with an interest rate swap tied to the federal funds rate. Fed funds is an overnight rate for the one-day loans that the Federal Reserve makes to banks that allows them to maintain minimum capital and liquidity levels. An interest rate swap is an exchange between two parties where party A pays a fixed interest rate—the OIS rate—to party B and party B pays a fluctuating rate—day-by-day fed funds earnings—to party A. The OIS rate is designed to anticipate and match the actual average of fed funds rates over a set time period.
The OIS rate is considered the more stable and less risky component; hence, LIBOR’s divergence from this metric illustrates banks’ perception of risk. When the spread increases, LIBOR is rising, which means banks are charging other banks more interest for interbank loans. Banks generally consider their peers to be the most trusted borrowers. When banks charge more interest on any loan, they are anticipating a higher risk that can only be justified with greater return in the form of larger interest payments. If banks think that fellow banks have an increased chance of defaulting, then expectations for the payback behavior of companies and individuals are even gloomier.
When the 3-month LIBOR veers from OIS, it means:
• Less money will be available for lending (decreased liquidity)
• Higher interest rates
• Less confidence in the market
When LIBOR numbers dip closer to OIS numbers, the spread narrows and the above negatives disappear. Traditionally, LIBOR and OIS have been within 10 basis points (0.10 %) of each other. All that changed with 2008’s autumn financial crisis. After the fall of Lehman Brothers, the LIBOR-OIS Spread became a financial Grand Canyon exceeding 360 basis points. This figure was the quick and telling measure of the paralyzed credit markets. Fear of default and collapse pushed interbank lending rates to extreme levels and essentially stopped all manner of loans.
By early 2009, the LIBOR-OIS Spread had fallen below 100 basis points,points; still gaping compared to the good old days but greatly improved over the bad recent days of Q4 2008. So if you want confident markets, accessible capital and reasonable interest rates, you’ll hope that LIBOR and OIS stay “close” friends.