Asbankers have returned to their desks this week after the summer break,they have been searching frantically for signs that the markets aregaining a semblance of calm after the August turmoil.
However,the money markets are notably failing to offer any reassurance. Whilethe tone of equity markets has calmed, the sense of crisis in theinterbank markets actually appears to be growing – especially in London.
Inparticular, the cost of borrowing funds in the three-month moneymarkets – as illustrated by measures such as sterling Libor or Euribor– is continuing to rise, suggesting a frantic scramble for liquidityamong financial groups.
This trend is deeply unnerving forpolicymakers and investors alike, not least because it is occurringeven though the European Central Bank and the US Federal Reserve havetaken repeated steps in recent weeks to calm down the money markets.
“Whatis happening right now suggests that the moves by the Fed and ECB justhaven’t worked as we hoped,” admits one senior internationalpolicymaker.
Or as UniCredit analysts say: “The interbanklending business has broken down almost completely . . . it is a globalphenonema and not restricted to just the euro and dollar markets.”
If this situation continues, it could potentially have very serious implications.
Oneof the most important functions of the money markets is to channelliquidity in the banking system to where it is most needed.
Ifthese markets seize up for any lengthy period, there is a risk thatindividual institutions may discover they no longer have access to thefunds they need.
This danger has already materialised forvehicles that depend on the asset-backed commercial paper sector –short-term notes backed by collateral such as mortgages.
In recent weeks, investors have increasingly refused to re-invest in this paper.
AsAxel Weber, a member of the ECB council, admitted this weekend: “Theinstitutions most affected currently are conduits and structuredinvestment vehicles . . . Their ability to roll these short-termcommercial papers is impaired by the events in the subprime segment ofthe US housing market.”
This problem is affecting the widerbanking system because these vehicles are now tapping other sources offinance – mainly liquidity lines from banks.
It appears that theprospect of receiving new liquidity demands has prompted banks to rushto raise funds – and, above all, hoard any liquidity they hold.
Thehigh demand from banks to secure liquidity for the next three months,coupled with their desire not to lend out what liquidity they have, hasmade it virtually impossible to execute trades – even at the officialprices quoted for such borrowing.
That has created someextraordinary dislocations such as the fact that the cost of borrowingthree-month money in the sterling Libor markets is now higher thanborrowing six-month or 12-month money. “The system has just completelyfrozen up – everyone is hoarding,” says one bank treasurer. “Thepublished Libor rates are a fiction.”
This situation could becomeincreasingly dangerous in part because many other markets, such asswaps, are priced off the three-month Libor and Euribor rates. So theinterbank freeze could have knock-on effects throughout the financialsystem.
A more pressing problem is the large volume ofasset-backed commercial paper due to expire in coming weeks, which isset to increase the scramble for cash by the banks. “Money marketstability needs to return as soon as possible,” says William Sels, ofDresdner Kleinwort. Jan Loeys, of JPMorgan, notes: “The longer itlasts, the greater the risk that the current liquidity crisis willworsen.”
The crucial uncertainty is what, if anything,policymakers can do to combat the sense of panic. Some observers hopethe problems in the sterling market, at least, may dissipate when thecurrent maintenance period at the Bank of England comes to an end.
Others,such as Mr Weber, have suggested that banks themselves need to raisemore funds in the capital markets to meet liquidity calls. However,many private sector bankers, for their part, say that radical stepsfrom the central bankers are needed to remove the sense of panic.
Whether the central bankers are willing or able to really help – in the UK or anywhere else – remains the great question.
Additional reporting by Paul J Davies
