Key Takeaways
• An overview of the interbank markets and why they exist.
• Understand the use and differences between LIBOR and OIS.
• Understand how LIBOR-OIS spread can act as an indicator to interbank credit confidence.
Interbank markets
The interbank market differs from the 'open market' as it only enables specific banks to trade with each other. The interbank market often refers to the interbank foreign exchange (FX) market where currency and currency derivatives are traded. There also exists an interbank lending market where short term loans are also traded amongst banks to enable them to better manage their capital reserves and liquidity requirements. This blog will focus on the interbank lending market.
The interbank lending market enables banks to manage their liquidity risk to meet stringent requirements. Amongst many, one reason these requirements are in place are to ensure the banks are able to withstand any potential 'bank runs' by customers. On the other hand, banks with excess levels of capital can lend their reserves to earn an interest income.
Why would banks want to lend to each other?
Imagine if Bank A has £10 million pounds. Bank A will be able to make a nice profit by lending £8 million of that loan to commercial purposes at an interest rate of 2%. But Bank A has not yet found a purpose for the other £2 million on it's books. So rather than letting it sit in the bank earning nothing, they can then lend to other banks in the interbank lending market for a set period of time until they find a more lucrative use for the capital.
Bank B may be a customer to Bank A as they may require extra short-term capital for their own books (perhaps to meet liquidity requirements or to satisfy a new loan opportunity). They are able to borrow capital on the interbank market at an agreed interest rate. Bank A and Bank B will agree a timeframe for which the money is lent; Bank A is happy as they find a use for their extra £2 million and Bank B is happy because they are able to satisfy their immediate capital requirements.
The banks that are participating in the interbank market tend to be of high-credit quality. The interbank market is unique as loans are made without collateral and at a very low interest rate to reflect the credit-quality of the participants.
LIBOR
LIBOR - The London Interbank Offered Rate is a variable interest rate that is used by banks for short-term, unsecured interbank lending, just as Bank A and Bank B would engage in.
LIBOR is a globally accepted benchmark and reflects the cost of lending between banks. LIBOR is calculated on the rate that a consortium of banks lend 5 currencies (USD, EUR, GBP, JPY and CHF) at 7 different maturities (overnight, 1 week and 1, 2, 3, 6, and 12 months) within the interbank market. Despite there being 35 different LIBOR combinations of currency and maturity, the 3-month USD LIBOR rate is most commonly quoted as the 'current LIBOR rate'.
The LIBOR rate is posted on a daily basis. It is calculated by the British Banking Association (BBA) who ask major global banks what they would expect to pay for a short term loan in the interbank market. The BBA then remove the tail-end values and calculate the average. This is known as a 'trimmed average'. The daily LIBOR rate is published by the ICE (Intercontinental Exchange) Benchmark Administration.
The rate that each bank offers for short term lending will change each day to reflect credit risk on the loan. Credit risk is the risk that the original loan amount will not be repaid. As the length of the loan increases, so does the credit risk, as there is a longer period of time where the loanee may default and be unable to repay the loan in full. LIBOR is known as a forward-looking interest rate as it is a determined rate that is set at the beginning of the loan, and is paid at the loan's maturity.
So why would an everyday person care about LIBOR?
As a bank customer, you may also be impacted by LIBOR. LIBOR is often used to determine the interest rate on various products such as credit cards, loans and mortgages. As LIBOR impacts the rate at which a bank can obtain a loan at, it will impact subsequent loans the bank makes to its customers to therefore ensure they remain profitable.
Overnight Index Swap
The overnight index swap is a fixed-floating interest rate swap. The swap uses an overnight index as the floating rate. The overnight index is calculated by compounding an overnight unsecured lending rate to a new maturity. The overnight unsecured index rate is reflective of a single central bank. Indexes include:
• SONIA: Sterling Overnight Index Average
• EONIA: Euro Overnight Index Average
• SARON: Swiss Average Rate Overnight Index
• Mutan Rate: Japanese Overnight Index Rate
The unsecured overnight interest rate is calculated each day using the volume-weighted average of all unsecured loans for that date of a certain value. For example SONIA uses the interest rate applied to all overnight unsecured loans made up to 6pm that day that are greater than 25 million pounds.
LIBOR vs OIS
The key difference between LIBOR and OIS lies in the credit risk they represent. As capital is actually exchanged with a loan using LIBOR, there is a real presence of credit risk that is accounted for in the rate. As the maturity of the loan becomes greater, the credit risk on the loan increases as the opportunity for the counterparty to default increases.
OIS differs as credit risk is virtually eliminated. The overnight rate for a loan accounts for almost no credit risk due to the immediate repayment made on the loan. There is a very small opportunity for the loanee to default on the repayment. The OIS is considered to be risk-free as principal is not exchanged for the swap, but rather the difference in the agreed fixed rate and the floating index rate at maturity.
The LIBOR OIS Spread
The LIBOR-OIS (also known as LOIS) spread compares both the floating rate of LIBOR for a given maturity, and the compounded OIS rate to the same maturity.
As a result, the LIBOR-OIS spread represents the rate of interest that is required within the interbank market to compensate for the additional credit risk that comes with LIBOR due to the longer maturity on loans and capital transferred. As a result, we can use the LOIS to gather an understanding for how banks see credit risk in the interbank market.
You can find the historical LOIS spread here. Notice in March 2020 there had been a huge spike in the spread. A possible cause for this may be the outbreak of Covid-19 and the global lockdown that subsequently followed. A similar spike occurred in 2008 prior to the financial crisis. LOIS can be considered a valuable indicator to the perception of credit risk within the interbank market.
LIBOR scandal
Earlier in the blog, we mentioned how LIBOR was calculated, and how it had been a competitive rate set by specific banks that were averaged out by the British Bankers Association. Unfortunately, this 'competitive' rate submitted by the banks were not always done so with the purest of intentions.
One assumption made within an investment bank is the presence of a 'Chinese wall'. This is a theoretical wall that prevents communication between different divisions of the bank that may have an influence on each other. For example, between the parts of the bank that submit their LIBOR rates to the BBA, and the traders whose derivatives have exposures on LIBOR. The implementation of the Chinese wall may not have been carried out so well with certain banks.
If the LIBOR submitters for a bank are aware that a specifically higher or lower LIBOR can benefit the net position of their traders, they may be motivated to post artificially high or low LIBOR rates to the BBA. It is also believed that up to 20 banks colluded to submitting LIBOR rates that were not strictly competitive to benefit their positions.
A further drive behind collusion in submitting LIBOR rates that were not competitive were to give a false premise for the banks position to borrow and lend in the market. If a bank considered themselves riskier to lend to, they may reduce the LIBOR rate they they think they can lend at. As a result the LIBOR rate for the day may be reduced, thus enabling the bank that submitted the lower rate to borrow more cheaply.
In the aftermath of the scandal, believed to have started since 2003, LIBOR is currently being phased out, expected to be completed by June 30 2023.
Summary
The interbank lending market enables banks to efficiently allocate and obtain capital depending on whether they hold excess amounts or require it for short-term unsecured borrowing. LIBOR is a variable interest rate that determines the rate which banks can lend to each other in 35 different currency/maturity combinations.
OIS is a rate used by banks to borrow overnight, and therefore reflects a reduced presence of credit risk in the pricing.
The LIBOR-OIS spread is a useful indicator to summarise the confidence banks have in lending to each other as it reflects the credit risk they perceive for longer term interbank loans.