Economic SYNOPSES
short essays and reports on the economic issues of the day
2009 ■ Number 24
What the Libor-OIS Spread Says
Daniel L. Thornton, Vice President and Economic Adviser
he term London interbank offer rate (Libor) is the
ity constrained, borrowing banks would have to pay a highrate at which banks indicate they are willing to lend
er rate when they borrow from each other than when they
to other banks for a specified term of the loan. The
borrow in the CD market, where lenders are not “liquidity
term overnight indexed swap (OIS) rate is the rate on a
constrained.”
derivative contract on the overnight rate. (In the United
States, the overnight rate is the effective federal funds rate.)
“Libor-OIS remains a barometer
In such a contract, two parties agree that one will pay the
of fears of bank insolvency.”
other a rate of interest that is the difference between the
term OIS rate and the geometric average the overnight
—Alan Greenspan
federal funds rate over the term of the contract. The term
OIS rate is a measure of the market’s expectation of the
Risks premiums generally tend to increase in an environovernight funds rate over the term of the contract. There
ment of increased uncertainty, such as periods of financial
is very little default risk in the OIS market because there
is no exchange of principal; funds are exchanged only at
turmoil and recession. In the case of recession, the risk
the maturity of the contract, when one party pays the net
premium increases because the rate on the default-risk-free
asset falls relative to the rate for the risky asset as interest
interest obligation to the other.
rates decline—there is a flight to safety.
The term Libor-OIS spread is assumed to be a measure
Figure 1 shows the daily term Libor-OIS spreads for
of the health of banks because it reflects what banks believe
terms of 1, 3, and 6 months: There was a sharp rise in the
is the risk of default associated with lending to other banks.
term spreads on August 9, 2007, after a lengthy period of
Indeed, former Fed Chairman Alan Greenspan stated
recently that the “Libor-OIS
remains a barometer of fears of
Figure 1
bank insolvency.” He then noted
4.00000
that “that fear has been substantially reduced since mid-October,
1-Month Libor-OIS
3.50000
3-Month Libor-OIS
but the decline has stalled well
6-Month Libor-OIS
short of any semblance of normal
3.00000
markets,” suggesting that the
still-high Libor-OIS spreads were
2.50000
an indication of problems in the
banking industry. There is no
2.00000
doubt that changes in the LiborOIS spread reflect changes in
1.50000
risk premiums rather than
changes in liquidity premiums—
1.00000
premiums that reflect banks’
0.50000
desire for liquidity: The difference between the rate on term
0.00000
certificates of deposit (CD) and
the equivalent-term Libor rate is
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Economic SYNOPSES
Federal Reserve Bank of St. Louis
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being small and relatively constant.
Figure 2
Indeed, there was little difference
in the spreads across terms of the
3.5
assets. This sharp rise in the term
6-Month AAA Corp-Treas Spread
6-Month Libor-OIS Spread
spreads is associated with market
3.0
concerns that problems in the subprime mortgage market were
2.5
spreading to the broader mortgage
market. These term spreads fluctu2.0
ated around a much higher level
until September 17, 2008, following
1.5
the announcement that Lehman
Brothers had filed for Chapter 11
1.0
bankruptcy. The spreads increased
to very high levels—about 350
0.5
basis points—for a period after the
Lehman announcement, but have
0.0
subsequently narrowed. Indeed,
the 1-month Libor-OIS spread on
April 6, 2009, was about 28 basis
points, only about 15 basis points
the Libor-OIS spread increased somewhat more than the
higher than it was before early August 2007. However, the
corporate-Treasury spread. Both spreads remain elevated
3- and 6-month Libor-OIS spreads remain much higher
before
the
Lehman
announcement.
relative to their pre-August 2007 levels, which likely reflects
than they were
It appears that the spreads reflect the market’s perception
the concerns associated with the recession. The fact that
of increased risk endemic to the economy more generally.
the Libor-OIS spread has averaged about 40 to 50 basis
Figure 2 shows the 6-month Libor-OIS spread and the
points more suggests that the risks might now be somewhat
spread between the rate on 6-month AAA-rate corporate
higher in banking than the economy more generally. However, this interpretation suggests that risks have risen more
bonds and the 6-month T-bill rate. The spread between
so in the banking industry despite considerable efforts of
lower-rated corporate bonds and equivalent-maturity
the government and the Fed to aid that industry.
Treasuries behaves similarly; however, the spread is much
wider. The 6-month corporate-Treasury spread reflects the
Finally, it is worth noting that there was considerable
risk premium in the economy generally. Both risk premiums
variation in the 6-month corporate-Treasury spread relative
increased dramatically in early August 2007. Hence, news
to the Libor-OIS spread before August 2007. Indeed, the
that the subprime problems were spreading beyond the
Libor-OIS spread was very small and nearly constant. This
behavior
is consistent with the idea that financial markets
subprime market appears to have affected risk premiums
were not adequately gauging the risk associated with mortin the economy generally and not simply the banking indusgage lending during the period. ■
try. Moreover, both risk premiums rose dramatically on
news of Lehman’s bankruptcy. Perhaps not surprisingly
Posted on May 11, 2009
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
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