Most traders didn’t pay much attention to the difference between two significant interest rates—the London Interbank Offered Rate (LIBOR) and the Overnight Indexed Swap (OIS) rate—a decade ago. Because the distance, or “spread,” between the two was so small until 2008. However, when LIBOR momentarily increased in proportion to OIS during the financial crisis that began in 2007, the financial industry took notice.
Today, the LIBOR-OIS spread is regarded as an important indicator of credit risk in the banking industry.
To understand why the difference between these two rates matters, it’s necessary to first understand how they vary.
The Intercontinental Exchange, the organization responsible for LIBOR, will discontinue releasing one-week and two-month USD LIBOR after Dec. 31, 2021. All other LIBOR rates will be phased out after June 30, 2023.
Defining the Two Rates
LIBOR (officially known as ICE LIBOR since February 2014) is the average interest rate that banks charge each other for short-term, unsecured loans. The rate for different lending durations—from overnight to one year—are published daily. The interest charges on many mortgages, student loans, credit cards, and other financial products are tied to one of these LIBOR rates.
LIBOR is designed to provide banks around the world with an accurate picture of how much it costs to borrow short term. Each day, several of the world’s leading banks report what it would cost them to borrow from other lenders on the London interbank market. LIBOR is the average of these responses.
The OIS, meanwhile, represents a given country’s central bank rate throughout a certain period; in the US, that’s the Fed funds rate—the key interest rate controlled by the Federal Reserve, commonly called “the Fed”. If a commercial bank or a corporation wants to convert from variable interest to fixed interest payments—or vice versa—it could “swap” interest obligations with a counterparty. For example, a U.S. entity may decide to exchange a floating rate, the Fed Funds Effective Rate, for a fixed one, the OIS rate. In the last 10 years, there’s been a marked shift toward OIS for certain derivative transactions.
Because the parties in a basic interest rate swap trade the difference between the two interest streams rather than the principle, credit risk isn’t a prominent issue in deciding the OIS rate. It also has little impact on LIBOR during typical economic times. However, we now know that during times of crisis, when various lenders begin to worry about each other’s solvency, this relationship shifts.
Prior to the subprime mortgage crisis in 2007 and 2008, the difference between the two rates was as little as 0.01 percentage point. At the height of the crisis, the disparity reached 3.65 percentage points.
The graphic below depicts the LIBOR-OIS spread before and after the financial crash. During the crisis, the spread expanded for all LIBOR rates, but it widened significantly more for longer-term rates.
The Bottom Line
The LIBOR-OIS spread reflects the difference between an interest rate that includes some credit risk and one that does not. As a result, when the disparity grows, it indicates that the financial industry is on edge.
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