Credit Crisis Watch: Banks Still Fragile

In order to gauge the progress being made to unclog credit markets and restore confidence in the world’s financial system, I monitor a range of financial spreads and other measures. By perusing these, as summarized in this Credit Crisis Watch review, one can ascertain to what extent the various central bank liquidity facilities and capital injections are having the desired effect.

First up is the LIBOR rate. This is the interest rate that banks charge each other for 1-month, 3-month, 6-month and 1-year loans. LIBOR is an acronym for “London InterBank Offered Rate” and is the rate charged by London banks. This rate is then published and used as the benchmark for bank rates around the world.

After having peaked on October 10th at 4.82%, the 3-month dollar LIBOR rate declined sharply to 1.09%. LIBOR is therefore trading at 84 basis points above the upper band of the Fed’s target range - a great improvement, but still steep compared to an average of 12 basis points in the year before the start of the credit crisis in August 2007.


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Importantly, US 3-month Treasury Bills have started making their way higher to 0.12% after momentarily trading in negative territory in December 2008, as nervous investors were in desperate search of safety.


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The TED spread (i.e., 3-month dollar LIBOR less 3-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free, while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.

Since the TED spread’s peak of 4.65% on October 10th, the measure has eased to a 5-month low of 0.97% - well above the 38-point spread it averaged in the 12 months prior to the start of the crisis, but nevertheless a strong move in the right direction.


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The difference between the LIBOR rate and the overnight-index swap (OIS) rate is another measure of credit market stress.

When the LIBOR-OIS spread increases, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans, so they charge a higher interest rate to offset that risk. The opposite applies to a narrowing LIBOR-OIS spread.

Similar to the TED spread, the narrowing in the LIBOR-OIS spread since October 2008 is also a move in the right direction.


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