Ten years ago, most traders did not pay too much attention to the difference between two important interest rates—London Interbank Offered Rate (LIBOR) and Overnight Index Swap (OIS) interest rates. This is because until 2008, the gap or “spread” between the two was the smallest. However, during the financial crisis that began in 2007, when the ratio of LIBOR to OIS spiked briefly, the financial sector noticed this.
Today, LIBOR-OIS spreads are considered a key measure of credit risk in the banking industry.
To understand why the changes in these two ratios are so important, it is important to understand the differences between them.
The Intercontinental Exchange is the agency responsible for LIBOR and will stop issuing USD LIBOR for one week and two months after December 31, 2021. All other LIBOR will cease after June 30, 2023.
Define two ratios
LIBOR (formally called ICE LIBOR since February 2014) is the average interest rate that banks charge each other for short-term unsecured loans. Announce interest rates for different loan periods (from overnight to one year) every day. The interest charges on many mortgages, student loans, credit cards and other financial products are tied to one of these LIBOR rates.
LIBOR aims to provide banks around the world with accurate information on short-term borrowing costs. Every day, several of the world’s leading banks report the cost of borrowing from other lenders in the London interbank market. LIBOR is the average of these reactions.
At the same time, OIS represents the central bank interest rate of a specific country/region during a specific period; in the United States, this is the federal funds rate-the main interest rate controlled by the Federal Reserve, usually called the “Federal Reserve”. If a commercial bank or company wants to switch from variable interest to fixed interest payments (and vice versa), it can “exchange” interest obligations with counterparties. For example, a U.S. entity may decide to change the floating interest rate, the effective federal funds interest rate, to a fixed interest rate, and the OIS interest rate. In the past 10 years, certain derivatives transactions have clearly shifted to OIS.
Since the parties to a basic interest rate swap do not exchange the principal, but exchange the difference between the two interest flows, credit risk is not the main factor that determines the OIS interest rate. During normal economic times, it will not have a significant impact on LIBOR. But we now know that in turbulent times, when different lenders begin to worry about each other’s solvency, this dynamic will change.
Before the subprime mortgage crisis of 2007 and 2008, the difference between these two interest rates was only 0.01 percentage point. At the height of the crisis, the gap was as high as 3.65 percentage points.
The chart below shows the LIBOR-OIS spread before and during the financial collapse. During the crisis, the gap in all LIBOR interest rates widened, but the gap in long-term interest rates was even greater.
Source: St. Louis Federal Reserve Bank
The LIBOR-OIS spread represents the difference between an interest rate with some built-in credit risk and an interest rate with little such risk. Therefore, when the gap widens, this is a good sign that the financial industry is in a state of tension.