In These New Times

Peston’s Blog

Something very strange and worrying is going on in money markets.

First the good news.

The two trillion pounds of taxpayers’ money that governments all over the world have put behind the banking system, both in the form of capital injections and guarantees for lending between banks, has reduced the perceived risk of banks going bust.

This reduction in the probability of banking failure is measurable, in that the price for insuring bank debt in the credit-default-swaps market has roughly halved over the past few days.

Here’s what you’ve been expecting: the less good news.

Banks are still not lending to each other at anything like a normal rate of interest relative to official rates.

The statistics (kindly updated for me by Barclays Capital) are extraordinary.

Back in the first half of 2007, before the onset of the credit crunch, the gap between what banks charge each for three-month loans, the three-month sterling LIBOR rate, and the average of expectations of the overnight interest rate for the following three months (the OIS rate), was 0.09 percentage points.

In other words, the three-month lending rate was closely aligned to expectations of what the Bank of England would charge for overnight money.

And that’s where the gap stayed for months – until the onset of the credit crunch in August of that year, when the gap widened to 0.23 percentage point, or 23 basis points in bankers’ lingo.

Which was wider than normal, but not devastatingly so.

Since then this interest-rate gap, known as the three-month sterling LIBOR-SONIA spread, has risen and fallen as the money-markets have become more or less stressed.

The more stress, the wider the gap or spread.

But the spread never got much above 1 percentage point, or 100 basis points.

Or at least not till September of this year.

Since when the gap has been widening and widening.

Last Friday, the spread reached what was probably an all-time record, of 219 basis points. That was a staggering 2.19 percentage points.

And it’s only narrowed a very little since then, to 202 basis points, or 2.02 percentage points.

You may think “so what?”

Well the “what” is big.

It means that banks are only prepared to lend to each other for three months at an interest rate that is a full two percentage points above the rate at which they expect to be able to borrow funds from the Bank of England over those three months.

Which means they just don’t want to lend to each other.

And, of course, if they’re not prepared to lend to each other for less than 2 percentage points above the expected policy rate, what chance that they’ll lend at a keener rate to consumers, households or businesses?

Slim to none, seems a fair bet.

A glance at the chart of the LIBOR-SONIA spread shows that last week’s half percentage point cut in the Bank of England’s policy rate has been more-or-less totally absorbed: almost none of that interest-rate cut has been passed on in the form of lower interest rates charged by banks when lending to each other.

Which is why only a relatively small number of mortgage rates and business lending rates have been reduced by the full half percentage point.

That’s distressing, because it seems to indicate that monetary policy has become toothless, ineffective.

At a time when we’re in a recession, it’s particularly worrying if cuts in interest rates by the Bank of England aren’t leading to reductions in the cost of credit for real people and real businesses.

And don’t forget that in the last few weeks, central banks – including the Bank of England – have literally been spewing loans of short-term and medium-term maturity into the banking system. And these central banks have been providing these loans in return for more and more eccentric and eclectic collateral.

Yet although there’s a ton of cash or liquidity sloshing through the system, banks want to hoard it rather than lend it.

What’s going on?

Well the widening in the interest-rate spread may in part reflect the margin demanded for the new interbank lending guarantees demanded by the Treasury.

But that would seem to me to be a relatively minor factor.

It may simply be the case that banks are so badly shaken by the 14 months of crisis in their industry that they have lost almost any appetite to lend.

They’ve made a decision to lend less, to deleverage, and no amount of cajoling or even bullying by the authorities is going to persuade them to do otherwise.

Which is highly undesirable, to put it mildly, when the real economy is showing every symptom of having caught a very bad cold from the sickness in the financial economy.