Many economists and investors consider the LIBOR-OIS spread an important indicator of the banking industry's financial health. As the spread widens, industry experts become concerned that it is indicative of an uncertain interest rate and lending environment. Uncertainties in the world of banks and investing generally equate to anxiety in the markets as any instability is viewed negatively. Understanding LIBOR, OIS and the relationship between the two will allow investors to make more informed decisions.
The London Interbank Offered Rate (LIBOR) is a widely watched rate around the world, much as the The Federal Funds rate is in the United States. Usually for terms of three months, the LIBOR rate is the interest charged (determined daily) for banks to borrow from other banks, without the need for collateral. The LIBOR provides institutions the means to quickly access needed capital at relatively low rates and without the need for putting any of their own assets (collateral) at risk.
Overnight indexed swaps (OIS) provide a means for banks to lock in a fixed rate for the length of the LIBOR loan term. The OIS rates and the associated spread are based on existing LIBOR interest rates (they can be based on other indices as well). The rates will vary up or down as determined by the market's sense of interest rate movements going forward. Since the LIBOR rates are determined daily, an OIS provides some stability to the banks and makes it easier to account for expenses. The other option would be to monitor the constantly fluctuating interest rates and determine the expenses associated with these rates each day.
The difference between the LIBOR rate and the fixed rate provided by an OIS is considered the spread. With daily changes in LIBOR rates possible, and OIS rates based upon expected interest rates over the term (often three months) of the loan, the spread is constantly moving. Staying in tune with the LIBOR-OIS spread can be a good tool for ascertaining the perceived strength of the credit and banking environments.
Prior to the debt crisis of the past several years, a usual LIBOR-OIS spread might be as low as 15 or 20 basis points (0.20% or one-fifth of 1 percent). However, as credit markets tightened the spread grew to as high as 200 basis points, or 2 percent, as recently as 2008. Many economists believe this was an indication of banks being either unable or unwilling to lend money to businesses and consumers.
High spreads increase the costs of lending (banks are not as likely to lock in such high rates for their LIBOR loans); as a result many institutions deem it too expensive to borrow, leaving them without the resources to lend. The overnight index swap rate is also viewed as a sign of the direction banks and investors believe the LIBOR is headed. A high spread indicates the belief that the LIBOR is going to rise, while small spreads indicate little or no perceived movement in near-term interest rates.