Fed funds vs LIBOR
I've been trying to wrap my mind around the current larger spread between the two rates. I understand the fed funds rate is targeted while LIBOR is market determined. However, if US banks are willing to lend to each other overnight at the fed funds rate, why could they not simply lend to the banks on which LIBOR is based at the same rate? For example, if some bank in England is facing a 5% libor borrowing rate, couldn't it go to a US bank, which would be wiling to lend at 4.25%? Does it have anything to do with overseas transactions with currency risk?
I am not 100% sure, but I think the participants in the fed funds and LIBOR markets are different. Many European banks use LIBOR, while US banks use fed funds. You can take the Fed funds-LIBOR spread as a rough indication that the risk profile of US banks are actually better than the Euro banks. In your example, the UK bank probably could not borrow at Fed Funds because of its risk profile.
fed funds only pertain to the reserves of banks and such held in the federal system. the Fed tries to control the supply of these reserves through open market actions, and try to reach the intended fed funds rate. fed funds are used only to satisfy reserve requirements of banks.
US banks DO NOT lend to each other at fed funds. They lend at Libor..
The widening spread means that banks are not willing to lend to each other at the rate intended by the Fed, probably due to uncertainty in the credit market. there is usually a spread, just not this much.
I think the reason that banks in Europe don't borrow at US rates is just that they are in different systems. European banks trade with other European banks at either Libor or Euribor.
US banks trade with each other at US Libor
to aachimp: you are totally wrong. US banks do lend overnight to one another at the effective fed funds rate, which the fed tries to maintain close to the target fed funds rate through open market operations. There are various means for banks to borrow, but borrowing overnight from other banks at the fed funds rate is the most common way for banks to satisfy the Fed's reserve requirements.
You can try reading Wikipedia for a start if you don't understand the subject matter: "In the United States the federal funds rate is the interest rate at which PRIVATE DEPOSITORY INSTITUTIONS lend balances (federal funds) at the Federal Reserve to OTHER DEPOSITORY INSTITUTIONS, usually overnight.1"
http://en.wikipedia.org/wiki/Federal_funds_rate
to clairfy, there is no one fed funds rate.
There is a fed funds target rate, that the federal reserve tries to target (currently at 4.25%).
In addition, there is the fed funds open and effective rate, which are market determined rates. The federal reserve tries to inject liquidity into the market to bring these rates in line with the target. Since the summer, the fed has not been as effective in brining Fed funds effective back to target, the average deviation used to be around 4 bps, and now is around 14 bps.
Although Banana Milkshake is technically correct about US banks borrowing with each other at Fed Funds, what excatly is a US bank is deceiving. Any bank with a US branch and registered with the Fed, is technically a US bank. Many European banks have at least one US branch and can participate in this market.
LIBOR is set in London, but LIBOR by itself refers to US Dollar Deposits held offshore. Why offshore? To avoid Federal Deposit requirements and FDIC insurance.
Right now, the biggest difference between the 1 month LIBOR (the most common LIBOR quote) and fed funds is due to the tenor, or maturity length. At year end, liquidity is generally tight, due to funding pressures (christmas bonuses, payroll) as well as a bit of windowdressing to make their books look better. This is why there is a jump in the rate of 1 month LIBOR and fed funds.
In the short-term markets, banks usually lend to each other on a discount basis. I.e. 4.83% discounted from the par value. Although this can be viewed as a spread to fed funds or libor, and is usually affected by both, quotes on the trading floors are in a discount basis.
Banana, I think you said the same thing that I did. Read the the first paragraph. Banks do lend to other banks for reserve requirements at the fed fund effective rate.
Now my question is, is Libor then used for everything but the reserve requirements?
Not sure if I'm more confused than before, but are you guys saying (or is aachimp saying) that fed funds is approximately the rate at which us banks lend to each other for reserve requirements, but for anything else, it's libor? I don't know much about how banks work, but I take it that banks frequently lend to each other for non-reserve reasons?
"Right now, the biggest difference between the 1 month LIBOR (the most common LIBOR quote) and fed funds is due to the tenor, or maturity length."
3mL is the market convention...the generic swap rates you see on bloomberg are all semi bond vs 3's.
See the graph in the article...
Effective Fed Funds vs Overnight LIBOR (Originally Posted: 10/10/2008)
For those of you who follow these things, is there any reason that effective fed funds has been sub 2% for most of the past few days/weeks but overnight Libor has skyrocketed and, I believe, stayed above effective fed funds by a significant margin? I understand fed funds is the rate at which US depository institutions lend their excess reserves to each other, but the loans are unsecured. Libor is based on a different set of banks and is not directly tied to excess reserves, but in the end, it is still a bunch of very large banks making unsecured overnight loans to one another. Why should fed funds be lower than overnight libor?
Bonus question: why do people look at the LIBOR-OIS spread (which I assume means 3m LIBOR vs 3m OIS) instead of LIBOR-Overnight LIBOR or something to that effect? Considering that Libor is based on a different set of banks and measured slightly differently than Fed funds (on which OIS is based), isn't there some disconnect there?
Apologies if this is too technical and interests no one. I just see these terms come up so much but not much explanation of their use.
THanks.
Here's an article that can articulate a potential response better than I:
http://ap.google.com/article/ALeqM5gXJkHBkXwQWtPp4EaKg_ly_7cM_AD93NSRGG0
It also addresses the fact that the overnight LIBOR has come down by almost 50% between yesterday and today.
Let me know what you think.
Thanks for the link.
"The fed funds rate is the overnight rate at which banks lend funds that are held by the Federal Reserve to other banks; the Fed therefore has some control over it. LIBOR, on the other hand, is the average bank-to-bank lending rate on the wholesale market, and is a better benchmark for global short-term interest rates."
That sentence relates to my question but the author is too vague to answer anything definitively. I understand that the fed's actions serve to bring effective fed funds to the target rate, but it should also influence Libor as a secondary effect. Put differently, the Fed really does have control over Libor, at least in regular markets. My question now is why their control over fed funds remains in the current dislocated market, but their control in Libor has completely evaporated, given that both rates are based on effective unsecured lending?
I disagree about the fed having indirect control of LIBOR:
The fed's action to lower the fed funds rate doesn't necessarily have to affect the LIBOR over in the UK. Why should it? LIBOR is derived from the average lending rates of the most credit worthy banks. So although the British Bankers Association gets together every morning with reps from all of the central UK banks, it is ultimately the input of these representatives which is averaged. Fed Funds rate on the other hand is directly regulated by the government (federal reserve). What they say goes. In these times, a government official will have different objectives (providing liquidity), than a representative of a central bank (maintaining a sound deposit base). Fed will be willing to make money cheap (lowering rates), while reps from banks will be interested in making money expensive (discouraging giving it out to other banks for fear of counter-party risk/credit/economic risk).
one of my VP's made me construct this exact graph (before the press) and originally i took a snapshot of sept 30 of each each from 2003 to 2008. the spread was marginal for all of the years and then it rocketed to over 200bps on set 30 2008. he made me update it when there was the 50bps rate cut and the spread widened to closer to 300bps. interestingly enough, the ECB base rate and the UK base rate vs. their libors are only around 100bps as of oct 8, but that might have changed in the last few days. (these are all for 3 month libors btw).
to answer the question, i think it means that the banks don't believe that they can lend out at such low rates because they have their own liquiity concerns. the government can slash rates all it wants, but the risks involved when the banks lend that low is too high. a lot of them would rather hord cash then lend at 1.5%+marginal spread. this is why people are saying the credit markets are drying up. you have to be a sure thing to be able to get money from banks, or anyone for the matter, in this market.
this problem is a lot worse than other problems like the tech bubble and i think the last time this spread drifted from norm is during the asia crisis, but i may be wrong. i am a relatively new analyst, so it'd be interesting for others more experienced members to add some input
Also, don't forget that another reason for the spike is not only that banks are concerned about their own liquidity, but they are worried that the counter-party will face a liquidity squeeze. This is particularly relevant, because it shows that banks are fearful of lending to other banks even on such a short-term basis.
two.N.twenty:
I am not talking about the fed funds target rate. The fed funds effective rate is the rate at which us depositories lend excess balances to each other, and it is a market rate. But it is indeed targeted by the government. In normal markets, the fed definitely has indirect control over LIBOR since the Libor-fed funds spread is tiny and stays constant. In this market, however, the spread is huge. Now, my question could also be phrased as, Why has effective fed funds rate remained so low? Why are US depositories willing to lend to each other at such low rates versus the rates that Libor-surveyed banks are? They are all large banks making unsecured loans to one another. Is there something special about the federal reserve system?
RE_Banker:
I agree with your statement "i think it means that the banks don't believe that they can lend out at such low rates because they have their own liquiity concerns."
My question though is more technical. Taking your statement as true, why are the banks in the federal reserve system willing to lend at such low rates? Fed funds has remained low in spite of all the media discussion around unwillingness to one another. These overnight loans, like overnight loans on which LIBOR is based, are unsecured.
the FOMC - hence open market operations, they buy/sell treasuries from the open market to add/remove liquidity from the market, they directly control the fed funds effective rate that's why it sticks pretty close to the target rate.
LIBOR is not controlled because it is a purely market driven inter-bank lending rate. Libor - ois (you are right it is the 3m tenors) spread is looked at since it shows you the risk aversion in the market. Libor shows counter party and liquidity risk while overnight index swaps carry the interest rate risk of the fed funds rate.
Why do banks have to borrow at a huge spread to what they technically can in the US? London branches of US and London banks can't borrow directly in the US and there are probably some sort of restrictions on just borrowing in the US and shifting it to London.
I was wondering about this. On the same topic, how is LIBOR pronounced? Is it "lee-bore" or "lie-bore"?
Mykyta, thanks for the reply.
"Why do banks have to borrow at a huge spread to what they technically can in the US? London branches of US and London banks can't borrow directly in the US and there are probably some sort of restrictions on just borrowing in the US and shifting it to London."
It seems to me like the spread between what US banks lend to each other at and the rate at which banks that report to BBA lend to each other at (surveyed for LIBOR) ought not be drastically different. You may be right about the restrictions on shifting cash from US to UK and vice versa but why would US banks be so confident about lending to one another in this environment? Why wouldn't they share the same concerns as their UK branches and counterparts?
Leo, it is pronounced lie-bore.
can someone explain ois to me?
OIS stands for overnight index swap. The way I think of it is that parties A and B enter into an OIS in which party A pays to party B the effective fed funds rate every night and party B pays to part A the OIS rate (i.e. the agreed-upon set rate, which is fixed) every night. In reality, the two parties simply settle at maturity.
OIS is basically a guess at what the effective fed funds rate will be for a given period. If it is for a short period in which nobody expects the fed to make any rate cuts or raise the rates, then it should be pretty close to the fed funds target rate.
One of my questions related to OIS throughout this thread is why the effective fed funds rate has actually managed to be close to the target fed funds rate throughout the period. We have all been hearing about how banks are terrified of lending to one another, so if the fed pumps money into the system, it should get clogged and the effective rate should become substantially higher than the target rate (LIBOR has increased in this manner). However, this has not happened and the effective rate remains low even though interbank lending has supposedly grinded to a semi-halt.
US banks can borrow at the primary rate (the discount window) at 1.75% right now directly from the Fed, which was a taboo before and sort of acts as a ceiling to interest rates in the US. The discount window is a main reason GS and MS became bank holding entities. The effective rate is regulated by the FOMC as mykyta said "they buy/sell treasuries from the open market to add/remove liquidity from the market, they directly control the fed funds effective rate that's why it sticks pretty close to the target rate". An example might help to explain it a little more. To keep interest rates low , the Fed repo buys securities (usually treasuries, fed agencies and GSE debt) and pays for them by making a deposit to the required reserves account of the underlying bank - I would imagine that the Fed itslef takes a hit if the other end of the repo does not repay, so there is actually no risk for the banks' required reserves.
Darkxfriend, great thread.
I'm afraid the answer to your question has more to do with mathematics then you may have expected. LIBOR as opposed to Effective Funds is set by a disproportionately small number of banks, namely: BoA, JPMorgan, Citi, MUFG, Barclays, CS, DB, HBOS, HSBC, Lloyds, Rabobank, Royal Bank of Canada, Norinchukin, RBS, UBS and West LB. Furthermore only the interquartile mean is calculated and whilst that may help simulate market conditions in normal times, I can't think of any bank in the above set which would be too willing to part with excess cash in times like these.
In the US, effective funds is a weighted average of all transactions arranged by major brokers between the hundreds of banks which populate the country. More competition between lenders (although, again, less of a valid reason nowadays), semi-government control and a larger sample set mathematically ... you know the rest.
As for your bonus question, I'm going to feebly guess: ... convention? Maybe Jimbo can share a trader's insight.
breaking them down gets confusing, think of the spread as the pulse of banks. When they're nervous about counter party risk and about their own liquidity, it shoots up and vice versa. Fed funds effective will always be close to target because it's actively managed by the fed, announcing a rate cut does lower the rates but it's open market operations (a nice example by BKBG) that actually adjust it. The discount lending window was an antiquated monetary policy tool before sht hit the fan but now that the stigma associated with borrowing through it is gone, it does in effect put a cap on the fed funds rate because as soon as a bank needs to more cash to fulfill it's reserve requirement with the FED it can just go there and get the cash.
Since OIS is a swap rate, fixed rate that a party agrees to pay in return for receiving a floating rate, that is based on Fed Funds as the floating leg, it won't shoot through the roof because of liquidity conditions and risk because it is managed. I imagine that's why LIBOR is spread to it. Spreading 3m libor to o/n libor won't have the same picture since even o/n libor spikes like crazy, look at the beginning of Oct.
That's my understanding of it at least.
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