The LIBOR-OIS spread is signalling a credit crisis could be brewing again...

One measure of the fear in the credit marketplace is the interest rate that banks charge each other compared to the safe overnight rate.

This is measured by the LIBOR-OIS spread. LIBOR is the London Interbank Offered Rate that banks charge each other for unsecured funds as quoted in London. The OIS is the Overnight Indexed Swap, the interest derived from the central bank’s overnight rate. In the U.S., the OIS is based on the fed funds rate.

The difference between these two rates offers a useful indicator of the risk perceived in the markets and the potential lack of trust banks have with each other. The credit crisis showed that big banks can collapse within a matter of days. No bank wants to be put in a position to recover loans to its peers / counter-parties over protracted periods of time and uncertainty because they have suddenly encountered "difficulties" and may not be able to repay.

The Bloomberg chart above shows how the spread was generally a low 10 basis points (0.1%) until the Credit Crisis. After October 2009, the rate returned to those low levels and has stayed low until this May. Was this recent period the “eye of the storm”?

As you can see, the LIBOR-OIS spread has doubled in just the last two weeks, a clear warning that the new turmoil around the Greek sovereign debt crisis is raising risk levels. Given the inter-connectedness amongst the international financial institutions, those with loans especially in the PIIGS nations may face higher borrowing rates as repayment risks increase. German, French and Spanish bankers with overseas loans in these regions therefore could be subject to more sleepless nights.


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