Question37 The LIBOR-OIS spread spiked from approximately 10 basis points to over 350 basis points during the 2008 credit freeze. What did this indicate? Central banks had raised official cash rates dramatically in response to inflation, directly pushing up the cost of short-term interbank borrowing The US government had effectively nationalised the interbank lending market, causing spreads to widen due to new regulatory fees and capital surcharges Banks were charging crisis-level rates or refusing to lend to each other entirely, reflecting a collapse of interbank trust due to opaque CDS exposures Mortgage default rates were actually declining, reducing the risk premium that banks required to hold long-term fixed income assets on their balance sheets ResetMaximum marks: 1 Flag question undefined

Question

BlackTom AI · Accepted Answer

The LIBOR-OIS spread measures the difference between unsecured interbank lending rates (LIBOR) and the overnight indexed swap rate (OIS), which reflects near–risk-free expectations of central bank policy. A sharp widening therefore signals elevated perceived credit or liquidity risk among banks relative to the near‑risk‑free benchmark.

1) Relevant knowledge points and concepts
- LIBOR: rate at which banks lend unsecured to one another; includes bank credit and liquidity risk.
- OIS: reflects the expected overnight policy rate and carries minimal credit risk.
- LIBOR‑OIS spread: proxy for interbank counterparty risk and systemic stress; larger spread = greater distrust or liquidity scarcity.
- Basis points conversion: 1 basis point = 0.01%.

2) Step‑by‑step reasoning
- Pre‑crisis spread ≈ 10 basis points = 0.10%.
- During the 2008 freeze it exceeded 350 basis points = 3.50%.
- Increase = 350 − 10 = 340 basis points = 3.40% additional premium.
- Such a jump means unsecured lending rates rose several percentage points above the near‑risk‑free rate because lenders demanded very large compensation (or refused to lend) for perceived counterparty risk.

3) Calculations (intermediate steps)
- 10 bp = 0.10%; 350 bp = 3.50%.
- Difference: 3.50% − 0.10% = 3.40% or 340 bp.

4) Why the correct answer is correct
- The huge spread indicates banks viewed each other as risky; they priced or withheld unsecured funding accordingly. This was driven by opaque exposures—securitised assets and credit default swaps—that made counterparty risk hard to assess, causing crisis‑level rates or lending freezes.

5) Why other options are incorrect
- Central banks raising official rates would raise OIS expectations and market rates but would not by itself produce a sudden spike in the spread driven by credit concerns.
- Government nationalisation with fees/capital surcharges is not the proximate cause of a rapid interbank risk premium spike in 2008.
- Declining mortgage defaults would lower risk premia and narrow spreads, not widen them dramatically.

6) Conclusion
The correct answer is: Banks were charging crisis‑level rates or refusing to lend to each other entirely, reflecting a collapse of interbank trust due to opaque CDS exposures. This matches the provided answer.

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