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Banks Don't want anything to do with each other, now what?

Unfortunately, the worst is still yet to come if you consider the Libor an inidcator.

Here's why:

1. The spread between Overnight Indexed Swaps (OIS) and the three-month LIBOR rose to an all time high of 2.94%.

The LIBOR/OIS spread measures the amount of cash available for interbank lending and is used by banks to determine interest rates. The wider the spread, the less cash there is to go around. This is telling us that banks, despite billions of central-bank support in recent months, are still cash-strapped and are disinclined to lend money either to each other or to consumers.

2. LIBOR, which equates to the rate that banks charge each other for overnight dollar loans rose to 2.37% yesterday, the British Bankers’ Association said.

For those of you who don't follow what the LIBOR is.....it's a set of rates, and is calculated for several currencies based on periods ranging from overnight to 12 months.

3. Last week as U.S. lawmakers tussled over a bailout plan and governments in Europe were forced to intercede to rescue five banks, the cost of one-month bank loans in euros and overnight dollar loans soared to records, which simply put means banks are hoarding cash!

4. Yesterday’s three-month LIBOR for loans in dollars jumped to 4.33%.

5. The TED spread, which is the difference between three-month LIBOR and what the U.S. Treasury pays for a three-month loan hit an all-time high of 3.93%, before pulling back slightly. The TED spread provides a gauge of how likely banks are to lend to each other, rather than to the Federal Government.

Under normal conditions, the banks charge each other premiums that are historically not much higher than government Treasuries.

Conclusion:

The fact that the spread is at all-time highs seemingly confirms that banks don’t want anything to do with one another, and would rather deal with the government.

To get interbank lending going again, banks must have confidence in each other’s solvency and liquidity.

How can we restore trust in these interbank relationships?

There are a number of options 3 of which are below, explained by one of the authors of the FT(Financial Times), Mr. Willem Buiter:

Nationalise the banks. When they have a common majority owner (the state), the state can simply instruct the banks to lend to each other. Problem solved. It may come to that in any case, but for those who are not ready for such measures, here are a couple more.
Guarantee interbank lending. Here the Treasury guarantees interbank transactions, both secured and unsecured. This should be done against fees that ensure the Treasury an acceptable risk-adjusted rate of return on this activity.
Have the central bank interpose itself as the universal counterparty for interbank transactions. This is effectively already the case in the overnight market in the UK and the euro area. When the Fed starts paying interest on reserves (commercial bank deposits with the Federal Reserve System), we will see the same phenomenon there. In the UK, for instance, banks hold large deposits overnight with the Bank of England at the standing deposit facility (which pays 100 basis points below Bank Rate (the official policy rate) )and borrow either by running down these overnight deposits or by borrowing overnight at the standing lending facility (at a rate 100 basis points above Bank Rate). The same phenomenon can be observed with banks in the euro area. That 200 basis points spread (between the standing deposit and standing lending facilities rates) is hefty, but banks prefer it to taking the counterparty risk of other banks, even overnight. Instead of commercial banks A and B lending directly to each other at longer maturities than overnight, bank A could lend to the Bank of England, and the Bank of England could then on-lend to bank B, more or less ‘on demand’. This would require the Bank of England to take a view of what the interbank rate ought to be at all the maturities where it acts as the universal counterparty of last resort - something it has been loath to do. It could do this either for unsecured transactions or for both secured and unsecured transactions. The spreads and other fees associated with this counterparty of last resort role would vary with the maturity of the loan, the quality of collateral, and the Bank of England’s assessment of the creditworthiness of the banks borrowing from it.

Posted by Paige Rausch on 10/07/2008 08:11 AM

Comments (2)

libor, nationalise banks, interbank lending, ted spread, ois

2 Comments on Banks Don't want anything to do with each other, now what?

OCT

2008

GREAT POST! I love how much detail you gave here! Nice!

Below is the Best summary on the events you describe Ms. Rausch~

"The euro will disappear within 20 years because of the inability of member states to stick to the rules underpinning the European Union's single currency."
-- Jim Rogers, 2006.

"Prodi's euro has screwed everybody."
-- Silvio Berlusconi, Prime Minister of Italy, July 2005.

The dramatic developments in Europe in recent days have shown a fundamental lack of coordination between European governments which is likely to put great strain on the cohesiveness of the European Union. As this crisis unfolds and if it deepens further it will become a life or death test for the euro.

Ireland's unilateral decision to guarantee all deposits and (more concerning) the debts of her six largest banks for a period of two years (which represent two times the country's GDP), followed by similar assurances from Greece and Germany (only regarding deposits) is very concerning.

Ad-hoc responses in an uncoordinated fashion by different governments are much less effective than a well coordinated response and leave the remaining governments in an even more difficult situation (i.e. increases the risk of capital draining out of a country's banks into safety of a nearby country's bank benefiting from a higher degree of government guarantees). This could lead to a sub-optimal result for Europe as a whole, a situation akin to game theory's prisoner's dilemma. Nouriel Roubini called it a "beggar thy neighbor policy" in a recent piece.

This is substantially more damaging than the Irish turning down the Lisbon Treaty in the recent referendum (which sought to provide a much needed overhaul to improve the governability of Europe's institutions post-expansion to the East). That this was initiated by Ireland is particularly regrettable as it is coming from the country that possibly benefited the most from the adhesion to the European Union. On second thought, this is perhaps not that surprising, as the Irish had been allowed to get away with fiscal dumping for decades, attracting businesses to be based in Ireland through very low corporate tax rates - at the expense of neighboring countries who, because of their larger size, or temperament, could not afford to have such a buccaneering attitude and eschew their responsibilities to the European project.

Different countries are being affected differently by the crisis. Some countries have a domestic housing bubble (e.g. Ireland and Spain) while others do not (Germany); some countries' banking systems have more leverage or more exposure to structured finance or US sub-prime, the precise contours of this landscape are still foggy but should emerge in the coming months. These differences make it difficult for countries to coordinate responses and find a policy that fits everybody.

Ultimately the crisis and the different responses will likely result in a further divergence of macro economic indicators, with some countries incurring substantial budget deficits and seeing further ballooning of their public debts because of the bailouts. At some point, if after suffering a couple of years the economy does not turn around, some countries may feel they need to regain monetary sovereignty to gain further degrees of liberty in dealing with the fiscal and economic crisis, so the temptation to pull out of the euro will be great, although this would surely take several years to play out.

The designers of the Monetary Union understood that its success would require a certain degree of economic and macro-economic convergence. So they created the Stability and Growth Pact (SGP), an agreement by European Union member states related to their conduct of fiscal policy, to facilitate and maintain Economic and Monetary Union of the European Union, namely seeking to keep the budget deficit under 3% of GDP and public debt under 60% of GDP. These rules were never strictly enforced (particularly if the countries in breach were Germany or France) but the current crisis will finally shatter any remnants of it.

One of the first casualties of a deep crisis is also truth, so the euro may be a convenient scapegoat for populist political leaders seeking to capitalize on the crisis for political gain.

The euro was always a highly ambitious and very difficult project, many (particularly on this side of the pond) did not believe it would ever see the light of day. If the euro survives this crisis, then it will become a more mature currency. I certainly wish it does, for the sake of Europeans and the world. But, unfortunately, the way things are going I would think long and hard before betting on it, we may be witnessing, I fear, the beginning chapters of the end of the euro dream.

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