The Libor / Overnight Indexed Swap (OIS) rate

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The TED spread may not be the cleanest measure of interbank worries.

OIS SpreadMore prominent of late has been the spread between Libor and the Overnight Indexed Swap (OIS) rate. An overnight indexed swap exchanges a fixed level of interest, the OIS rate, for the amount earned by fed funds over the term of the swap. The counterparties to such a swap bear minimal credit risk, as they simply make payment based on the difference between a fixed rate and a stream of variable rates. With a conventional Libor loan, by contrast, the lender bears the credit risk of the borrower for the entire principal plus the Libor interest.
As a result, the Libor/OIS spread is perhaps the clearest indication of pure counterparty risk. Like the TED spread, the Libor/OIS spread surged in August 2007. Formerly ensconced comfortably in the neighborhood of 10 basis points, the three-month Libor/OIS spread has fluctuated wildly in the past year, even exceeding 100 basis points for several days in December 2007. But the spread remains elevated in 2008, with recent readings holding well above 80 basis points.1
Despite the liquidity facilities arranged by central banks and the massive influx of capital into troubled financial institutions, the Libor/OIS spread reflects persistent nervousness in the global banking system. The multiyear issuance period for complex assets that have since become impaired suggests that confidence in bank balance sheets will only return gradually, as the slow but steady lessons of cash flow experience help frame balance sheet valuations.