Oct 082008

The acronym, W.I.I.F.M., is based on an ethos which lies at the root of human nature. It stands for What’s In It For Me. Let’s be honest, and admit that it pervades our daily lives in practically every aspect. Why should I do something for someone, if there’s nothing in that ‘doing’ for me? Altruism, as much as we’d like to think otherwise, doesn’t figure largely in the human psyche.

When it comes to dealing with people’s finance requirements, acronyms abound. Probably the most prevalent acronym at the moment, and the least understood, would be L.I.B.O.R. The acronym stands for London Inter-Bank Offered Rate. This rate is determined to be a measure of the rates banks and lending institutions across the globe are prepared to charge each other for the money which changes hands on a demand-supply basis, daily. LIBOR is a creature of the mid to late 1980’s. A time when global financial markets were undergoing the beginnings of a new wave of growth and the British Bankers Association (somewhat of a misnomer), an industry collective of some 200 member institutions in sixty nation states, decided some measurable benchmark was required by which to gauge global fiscal activity. LIBOR, or as some prefer to call it, LIBOR-OIS, was derived from this perceived ‘need’. The ‘OIS’ standing for Overnight Index Swap”. OIS are interest rate swaps where the floating rate is the geometric average of an overnight floating rate, typically a rate considered less risky than the corresponding interbank rate, or LIBOR.

LIBOR-OIS is referred to as an interest rate spread. The LIBOR-OIS spread is a comparison between the London Interbank Offered Rate (LIBOR) and the overnight index swap (OIS) rate. You see, analysts aren’t too concerned with the nominal value of each of these rates. What they are concerned with is the relationship between these two rates. Typically, LIBOR is higher than the overnight index swap rate, but knowing that alone isn’t enough. You need to know what the spread is.

When the LIBOR-OIS Spread is increasing, it tells us that banks believe the other banks they are lending to have a higher risk of defaulting on the loans so they are charging a higher interest rate to offset this risk. It also tells us that the credit markets are not functioning as smoothly as they could be—which is sign of potential economic contraction.
When the LIBOR-OIS Spread is decreasing, it tells us that banks believe the other banks they are lending to have a lower risk of defaulting on the loans so they are charging a lower interest rate to offset this risk. It also tells us that the credit markets are functioning smoothly—which is sign of potential economic expansion.

It’s this spread, especially over recent times, which has become the measure of global financial market stability, solvency and confidence. In January 2008, the LIBOR-OIS spread was 24 basis points, or 0.24%. As at 2 October 2008, that spread was 254 basis points. 2.54%. Given the average spread in the twelve months immediately prime to the so-called Sub-Prime Crisis coming to the surface was 8 basis points, it’s plain that confidence between global financial markets has evaporated.

So, what does WIIFM have to do with global financial markets? Everything. Risk levels are perceived to be all but unacceptable between major financial institutions, primarily because no single institution is prepared to admit that it’s exposure to complex trading instruments might be less than prudent. This means that money is very hard to get, and consequently, expensive. Do a simple sum and add 2.54% to Australia’s benchmark cash rate of 7% and you get a gauge of just how expensive some risks can be assessed to be. WIIFM comes into play, even in Australia’s supposedly well regulated and soundly capitalised financial markets just as much as it does overseas simply because our banks are exposed to the same complex financial instruments traded globally, just as banks in Japan, Luxemburg, Sweden and Canada are. The exposures just aren’t as broad and deep. At least that’s what we’re told.

So even here in Australia, when one bank wants or needs to borrow from another, the question is asked. “What’s in it for me? You want me to take a risk, so make it worth my while.” The cost of money currently has nothing to do with greed, but everything to do with confidence and trust between financial institutions, domestically and globally. In many ways, it’s classic supply/demand. Demand for money is increasing because the supply is drying up, so the price rises.

Technorati Tags: ,,

This site uses Akismet to reduce spam. Learn how your comment data is processed.