Definition of Ted spread

This is the difference between the interest rate at which the US Government is able to borrow on a three month period (T-bill) and the rate at which banks lend to each other money on a three month period (measured by the Libor).

Since, arguably, the risk of a bank defaulting is slightly higher than that of the US government defaulting, the Ted spread measures the estimated risks that banks pose on each other.  The higher the perceived risk that one or several banks may have liquidity or solvency problems, the higher the rate you will ask from your loans to other banks compared to your loans to the government.

Consequently, the Ted spread is a great indicator of interbank credit risk and the perceived health of the banking system. [1]

Example
In 2008, the Ted spread peaked at 450 basis points after the collapse of Lehman Brothers.

In 2010, the Ted spread has returned slowly to its long-term average of 30 basis points, hitting a low of 11 basis points in March, as confidence returned. But as the Greek debt crisis escalated into widespread fears about the health of the eurozone, the Ted spread started to rise again, moving above 45 basis points by mid-June. [2]

When the Ted spread goes up, the interbank default risk is considered to be higher and when the spread decreases, the interbank default risk is considered to be lower.

When there is a downturn in the economy, banks suspect that some banks may encounter problems.  However, they do not know which banks, so they restrict interbank lending, resulting in higher Ted spreads and lower liquidity in the interbank market, which ultimately produces lower credit availability for consumers and corporates. [3]

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