What the Libor-OIS Spread Says

Abstract

T he term London interbank offer rate (Libor) is the rate at which banks indicate they are willing to lend to other banks for a specified term of the loan. The term overnight indexed swap (OIS) rate is the rate on a derivative contract on the overnight rate. (In the United States, the overnight rate is the effective federal funds rate.) In such a contract, two parties agree that one will pay the other a rate of interest that is the difference between the term OIS rate and the geometric average the overnight federal funds rate over the term of the contract. The term OIS rate is a measure of the market’s expectation of the overnight funds rate over the term of the contract. There is very little default risk in the OIS market because there is no exchange of principal; funds are exchanged only at the maturity of the contract, when one party pays the net interest obligation to the other. The term Libor-OIS spread is assumed to be a measure of the health of banks because it reflects what banks believe is the risk of default associated with lending to other banks. Indeed, former Fed Chairman Alan Greenspan stated recently that the “Libor-OIS remains a barometer of fears of bank insolvency.” He then noted that “that fear has been substantially reduced since mid-October, but the decline has stalled well short of any semblance of normal markets,” suggesting that the still-high Libor-OIS spreads were an indication of problems in the banking industry. There is no doubt that changes in the LiborOIS spread reflect changes in risk premiums rather than changes in liquidity premiums— premiums that reflect banks’ desire for liquidity: The difference between the rate on term certificates of deposit (CD) and the equivalent-term Libor rate is very small. If banks were liquidity constrained, borrowing banks would have to pay a higher rate when they borrow from each other than when they borrow in the CD market, where lenders are not “liquidity constrained.”