Capital Markets

The Big Thaw

Frozen credit markets are coming back to life.
Economist StaffOctober 22, 2008

THE world’s banking system may still be in intensive care, kept alive largely with the help of generous infusions of capital, liquidity and guarantees on lending from governments. Yet there are hopeful — albeit tentative — signs of recovery.

An important indicator of its health is the price that banks say they expect to pay to borrow money for three months, which is usually expressed as the London Interbank Offered Rate (LIBOR), or its European equivalent, EURIBOR. These have been ticking down slowly, often by only fractions of a percentage point a day. Yet on Tuesday October 21st the rate for borrowing euros passed an important milestone, falling to 4.96 percent, a level last seen before Lehman Brothers collapsed in mid-September. The LIBOR spread over three-month American Treasury bills has also narrowed sharply. The recent improvements were partly stirred by the latest lavish intervention from the Federal Reserve. It made available $540 billion to buy assets from money-market funds, to encourage them to start buying commercial paper issued by banks and companies again.

The pace of LIBOR’s recovery may look glacial, but it is actually faster than meets the eye. This is because LIBOR, the heart-rate monitor of the financial markets, seems to have gone on the blink. When markets were at their most stressed it underestimated the full cost to banks of borrowing — partly, in its defence, because there was so little lending in the interbank markets. The rates now being paid by banks to borrow may actually be half the level during the most intense moments of panic earlier this month.

More importantly, money is once again starting to flow through the system. “Compared with three weeks ago borrowing volumes are up by as much as ten times,” says Tim Bond of Barclays Capital. The trouble, however, is that the banks still need a lifeline from central banks, which have opened the floodgates of dollars and euros. The European Central Bank, for instance, has loaned €773 billion ($1 trillion) to banks.

The best indicator of a healthy financial system would be banks once again lending money to one another. There is improvement here, too. American banks including JPMorgan Chase and Citigroup have, in the past week, made loans to European counterparts for up to three months. And HSBC, Europe’s biggest bank, says it is providing billions in three- and six-month funding to banks.

Markets for longer-term credits for banks are also gradually returning to life as institutional investors regain their nerve. On October 17th Lloyds TSB managed to sell £400m ($690m) worth of ten-year bonds—the first such issue by a European bank since the collapse of Lehman. As of Wednesday Barclays was planning to borrow €3 billion over three years by issuing notes backed by the government. But the cost of borrowing remains uncomfortably high. Lloyds TSB, for instance, paid 2.25 percentage points above the interest rate on an equivalent government bonds. Barclays, which will be charged about 1.5 percentage points by the government for the guarantee of its bonds, may end up paying almost as much as Lloyds for its borrowing.

Meanwhile, banks are exposed to further possible write-downs which could strain money markets once more. More businesses are going bust, which will put further pressure on the vast credit-derivative markets. Consumer loans are souring. If another big bank were to come close to failing, the financial system might yet be back on life support.