Why the Libor OIS spread measures stress in the banking system

AEP's piece in todays DT business notes the above. It was a measure much favoured by Alan Greenspan when he ran the Fed. To understand it you obviously have to know what Libor and OIS are so here goes for a concise explanation.

Libor stands for London Inter Bank Offered Rate and is the rate at which London banks will lend in size, say £100mn to £500mn, to other London Banks at various tenors from overnight to one year. The most important are the 1 month and 3 month rates. It is compiled daily by the BBA at 11:00 each day for a wide range of currencies by phoning 16 panel member banks for their rates. They then discard thetop 4 and bottom 4 and take the average of the middle 8 and that is the Libor rate they publish at 12:00. Simples!

OIS stands for Overnight Index Swap. It is a OTC market based swap rate over 1 week to 1 year tenors that settles against the geometric average of the published daily overnight rate between large banks. It is a huge market particularly in Euro dominated by less than 10 of the very largest banks in the world. The size of deals are in billions so roughly 10 times bigger than Libor deals and the figures are compiled by the ISDA. Again the most traded is the 3 month rate. It is a rate at which deals are actually done and is a proper weighted average. Positions in this instrument can be daily marked to market if needed.

So Libor is an unsecured offered rate between most banks calculated from a sample response so in that sense it can be manipulated. OIS is a harder market rate between the very biggest most credit worthy banks in the world. Hence Libor will trade above OIS usually by around 10 basis points representing the credit difference between the biggest and best run banks and the second division banks. At times of stress when lending to the second division is seen as more risky the spread widens and has gone out to 364 bps in October 2008 at the height of the credit crunch! So its worth watching. Click on this link to see a Bloomberg chart of this effect.

Well done AEP for reminding us of this and also for noting Spanish 10 year sovereign bond yield dropped 11 bps yesterday as the market felt Spain was starting to sort out its banking problems. The German banks who have been obscure about the amount of Eurocrap they hold are the bad boys this week and as I noted yesterday their bond yields have gone up.