British Interbank Lending Drops

Volume Suggests Bank of England's Remedies Are Ineffective

Lending between British banks slumped in July as financial institutions hoarded cash, signaling that Bank of England efforts to revive money markets amid a surge in subprime mortgage losses aren't working.

The volume of interbank lending in the British currency fell to 205 billion pounds, or $370 billion, from 635 billion pounds in July last year, according to central bank data published yesterday. The reading is down 24 percent from the average since the credit crunch started in August 2007, and down 38 percent for the five years ending December 2006.

Banks have racked up losses of more than $500 billion since the collapse of the U.S. subprime mortgage market. Interbank borrowing rates are little lower now than they were in April, when the Bank of England offered to take on damaged mortgage-backed bonds in an effort to unfreeze lending. The strains in global money markets will probably persist "for some time," the Bank for International Settlements said yesterday.

"We're in the same position we were in last year, with banks hoarding cash to refinance their own beleaguered balance sheets," said Christoph Rieger, a fixed-income strategist at Dresdner Kleinwort in Frankfurt. "The Special Liquidity Scheme has helped individual banks by preventing them from becoming illiquid, but it hasn't helped money markets return to normal."

The July figure, which excludes central bank transactions, is down 68 percent from a year earlier. Part of the decline is due to changes in the number of institutions reporting to the central bank, according to the bank's Web site.

The central bank program allows commercial banks to swap mortgage-backed securities harmed by the credit squeeze for government bonds. The lending freeze led to the collapse of mortgage lender Northern Rock in September, triggering the first run on a British bank in more than 140 years.

The credit famine and the fastest inflation in at least a decade have brought Britain to the brink of a recession. Gross domestic product stagnated in the second quarter, ending the nation's longest stretch of economic growth in more than a century, according to government data.

Bank of England Governor Mervyn King said in June that he will unveil a new money-market system this year to cope with both "normal" and "stressed" conditions. He hasn't said when or whether banks will reveal their participation in the April plan.

"It's significant that lending volumes have stopped falling, but what's worrying is the level where they've stabilized," said Lena Komileva, an economist at Tullett Prebon in London. "This new order reflects weak confidence in credit quality as a result of banks struggling to refinance their loan books."

Interest rate derivatives imply that banks are becoming more hesitant to lend on speculation that credit losses will increase as the global economic slowdown deepens.

The premiums banks charge one another for three-month cash relative to the overnight indexed swap rate widened to 78 basis points yesterday from 12 basis points on July 31, 2007, before the credit crunch took hold in Britain. It has averaged 69 basis points in the past 12 months, up from an average of 11 basis points the preceding year.

"The term structure of Libor-OIS spreads suggests the interbank market pressures are expected to continue for some time," Ingo Fender and Jacob Gyntelberg, analysts at the BIS, wrote in the Basle, Switzerland-based bank's quarterly report.