When the LIBOR-OIS Spread is decreasing, it tells us that banks believe the other banks they are lending to have a lower risk of defaulting on the loans so they are charging a lower interest rate to offset this risk. It also tells us that the credit markets are functioning smoothly—which is sign of potential economic expansion.
Before the onset of the turmoil in the credit markets inAugust 2007, the LIBOR-OIS spread was around 10 basispoints. However, in just over a month, the spread rose to 85 basis points on September 14, 2007, when the Bank of England announced emergency funding to rescue the troubled NorthernRock, one of the U.K.’s largest mortgage lenders. The spreadreached its all-time high at 108 basis points on December 6,2007. Around the same time, large investment banks such asUBS and Lehman Brothers announced huge write-downs. OnMarch 17, 2008, the collapse of Bear Stearns led to an 83-basis-point spread, a 19-basis-point increase from the previoustrading day. In the latest illiquidity wave following the failureof Lehman Brothers, the spread was 365 basis points (as ofOctober 10, 2008). In short, the LIBOR-OIS spread has beenthe summary indicator showing the “illiquidity waves” thatseverely impaired money markets in 2007 and 2008.
Why A High LIBOR-OIS Spread Indicates A Limited Availability Of Credit
Banks must have a certain amount of reserves to conduct their business. During the course of the day, they may receive or pay out more money than expected. Depositors, for instance, may make big deposits or big withdrawals—banks can't know ahead of time what the net demand will be, hence, they need to keep a certain amount of cash to service customers. However, banks don't want to keep more than they need, because cash kept in vaults doesn't earn any interest, and, reserves held in central banks pay little or no interest. So banks with excess funds lend to banks needing funds. When this interbank lending market declines because of higher interest rates, then banks are forced to hold more cash to conduct business; hence, they lend less, not only to other banks, but also to consumers. Less lending means there is less money in the economy, which lowers demands for products and services, causing their prices to decrease—deflation.
Generally, credit risk increases interest rates more for longer term loans than for short-term loans. The spreads for the 1-month and 3-month LIBOR-OIS rates have been reported by the press as representative of the credit risk in interbank lending.
The 1-month LIBOR-OIS spread has averaged 6 basis points from January, 2006 to August 1, 2007. During the Credit Crisis of 2007 and 2008, the maximum spread was over 100 basis points.
In this 3-year graph of the 1-month LIBOR-OIS spread for the United States dollar (USD), the marked increase in the difference of the 2 rates is evident starting at the beginning of the Credit Crisis in August, 2007, with a wider spread in September, October, and November of 2008 indicating worsening conditions. As you can see in the below chart, prior to August, 2007, both the LIBOR and the OIS rates were high because the Federal Reserve, which is the central bank of the United States, raised their rates. After the beginning of the credit crisis, the Federal Reserve started lowering rates, and the OIS rate has declined with it. The LIBOR, however, has declined sporadically and not nearly as much as the OIS rate, because banks couldn't be sure which banks were creditworthy; hence, they charged higher interbank lending rates, which is what the LIBOR measures. This widened the spread between Libor and the OIS rate.
Spread during credit crisis
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"Quantitative easing" refers to the creation of money by a central bank in a pre-determined quantity out of 'thin air'. This central bank trick is what helped thaw out the credit freeze that was vexing all of the world's markets starting in October of 2007, and lasting until very recently.
Quantitative easing can basically be understood as a method of 'printing money' although today the new money is generally created electronically rather than physically printed. The usual method of increasing the money supply is by decreasing the interest rates at which the central bank lends to private banks and the monetary policy of quantitative easing is usually only applied when the interest is already at or close to zero and there's still not enough money in circulation to stimulate the economy. See the below chart to understand the effect that quantitative easing had on the Libor-OIS spread.
Spread after credit crisis
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