OK. So, stock markets are, like, tanking.
But the new conventional wisdom has it that stock markets aren't really where the action is. To gauge how the crisis is unfolding, we are told, we should pay attention to credit indicators, particularly indicators that compare the cost of interbank lending to the cost of "risk-free" government borrowing, such as the TED spread.
Felix Salmon has done a nice job of pointing out the flaw in these indicators: Banks don't actually have to borrow at the elevated interbank rates, as long as central banks are willing to lend directly at much lower rates. So, it's unclear whether interbank borrowing rates like LIBOR are meaningful as measures of interbank counterparty risk. As Felix notes:
Libor is an indicative rate: it's the rate at which banks would lend to each other, if they were lending. If they stop lending, they still need to report some interest rate to the Libor committee. But it might well bear very little relation to banks' cost of funds in the real world, where the interbank markets are becoming increasingly dried-up and unhelpful.
What is very clear is that LIBOR serves as the basis of many thousands of private sector contracts, and that the banking system as a whole is a net receiver of LIBOR-indexed funds. To the degree that LIBOR does not reflect banks effective cost of funds, an elevated rate can be viewed as a hidden tax of the nonfinacial sector by banks. Rather than reflecting the banking system's pain, a high LIBOR might indicate banks' ability to leverage their collective insolvency to charge higher rates on nonfinacial firms without complaint.
The oddest duck in the credit indicator menagerie is the LIBOR-OIS spread. That's a measure of the difference between what banks claim they have to pay to borrow from one another and what the market actually expects they would pay, if they adopted a strategy of borrowing overnight from, err, one another in the Federal Funds market. Both legs of the LIBOR-OIS spread represent unsecured interbank lending, so it's not obvious how this measure captures counterparty risk. It does, to a degree, because counterparties of a bank rolling overnight loans can choose not to renew the credit, should bad news strike, while a bank that extended a term loan at 1-month or 3-month LIBOR can do nothing but watch the fall. In a sense, LIBOR-OIS can be viewed as the price of an option to call a loan, to the degree that LIBOR accurately reflects the cost of interbank term financing.
But since US banks can borrow from the Fed's discount window at the Federal Funds rate + 25 basis points, while adjustable rate loans from banks are often indexed to LIBOR, a simpler way to think of the LIBOR-OIS spread is as a measure of the difference between the cost to banks of central bank money and rate they charge on private loans. Put this way, it is hard to understand why banks are upset that this indicator is elevated.
If this seems overly cynical, it's worth considering what happened to a LIBOR predecessor, the Prime Rate during the last US banking crisis.
|Steve Randy Waldman — Saturday October 11, 2008 at 10:53pm