March 14, 2014

TED spread: Indicating Credit Risk?

The difference between the 3-month LIBOR rate and the 3-month Treasury rate, also called the TED spread, is a commonly used indicator for the perceived credit risk in the general economy. Defining this spread requires an explanation of its parts. As a rule of thumb, the TED spread tends to be wide if banks view loans as risky and investors are nervous. In contrast, it will be small when markets are stable. We will now identify the parts of the TED spread.

We start off by defining the LIBOR rate.  The LIBOR is an interest rate which serves as a benchmark for the interest rates charged by banks when they lend funds to each other. The market where banks lend funds to each other is called the interbank market. So as some might have noticed, the LIBOR is actually an abbreviation. More specifically it stands for the London InterBank Offer Rate. This interest rate is determined by the average of borrowing costs of global banks, discarding upper and lower quartiles. It’s important to realize that banks all around the world use the LIBOR as a base rate for setting their own interest rates on loans. In order to see the importance of the LIBOR, one should know that hundreds of trillions of dollars in securities and loans are linked to the LIBOR. When the LIBOR rises, rates and payments on loans often rise. Similarly, they fall when the LIBOR goes down.

Second, the U.S. Treasury Bill rate can be seen as being risk-free. Thus the size of the TED spread indicates the liquidity premium in the market, as the LIBOR indicates the credit risk of lending to banks. The TED spread can widen due to an increase of the LIBOR or a decrease of the Treasury rate. We already have discussed the widening based on the LIBOR rate. The widening of the TED spread, based on the Treasury rate, occurs because banks want to get first-place collateral in times of crisis. This means that they will like to hold more Treasury bonds, pushing down the Treasury rate. We give a visual representation of the widening of the TED spread during crisis times below. In this graph an overview is given of the TED spread between April 2007 and January 2009, indicating the recent financial crisis.


In the following part we discuss the manipulation of the LIBOR, also called the LIBOR fixing scandal. During the financial crisis, banks manipulated the LIBOR rate in order to show a healthier picture of their credit quality and ability to raise funds. Namely, the true LIBOR rate would reveal problems with respect to the ability to borrow funds from the market. Thus the LIBOR rate was kept at a level that was unrealistically low. In the beginning of the financial crisis, the credit markets for banks started to freeze up. Banks began to suffer losses on their holdings of toxic securities relating to American subprime mortgages. As a consequence, banks were reluctant to lend to one another which led to shortages of funds. So there was little data in submitting LIBOR. This allowed for the opportunity to set LIBOR rates that did not match reality. Several banks were taken under the loop in the investigations but in order to demonstrate the event, we would like to refer to the following graph. This shows the range of different LIBOR rate submissions by banks after the Lehman Brother collapse. As you can see, before this point the rate submissions were very similar. 


The investigations into the fixing of the LIBOR rate by the national authorities led to global penalizations of numerous large and well-known banks. The European Commission, for instance, fined six financial institutions including Deutsche Bank and Citigroup with the highest antitrust penalty and the highest penalty for rigging financial benchmarks ever.
"What is shocking about the Libor and Euribor scandals is … the collusion between banks who are supposed to be competing with each other"

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