Mutual Distrust Freezes Lending Among Banks

By Neil Irwin
Washington Post Staff Writer
Wednesday, October 1, 2008

At the core of the financial crisis is a simple problem: Banks don't fully trust each other. So they hoard cash and only lend to each other if the borrowing bank pays enough to justify the risk.

The best indicator of the simmering interbank distrust is an obscure-sounding interest rate known as Libor, which is flashing red. Libor, or the London interbank offered rate, is the rate that banks worldwide charge each other for short-term loans.

Yesterday, the annualized rate for those overnight loans spiked by more than four percentage points, to 6.9 percent, its highest level ever. Normally, Libor on dollar loans is not much higher than what it costs the U.S. government to borrow short-term money, which yesterday was nearly zero.

That tells experts that banks around the world are basically unwilling to lend to each other at any price. It means that cash is not flowing to places that need it. And, if sustained, would ultimately lead to higher borrowing costs for ordinary U.S. households and businesses.

"The interbank markets are a fundamental part of the plumbing of the financial world," Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said in a speech yesterday. Many variable-rate mortgages, corporate loans, and other forms of debt adjust relative to Libor.

"This contraction in availability and rise of the cost of credit have worsened . . . for corporate and business borrowers," Lockhart said. "We've heard anecdotes confirming this from contacts throughout the Southeast. In short, Main Street is being affected."

When the Federal Reserve lowers the interest rate it directly controls, it helps stimulate the economy. But the rise in Libor, economists say, is likely to have the opposite effect, slowing the economy at the worst possible time.

The high lending rate reflects banks' fears: They have no confidence that the other guy will be able to pay the money back, even when the loan is only for a single day.

"There's just an environment of distrust right now, and that's the core of this entire crisis," said Ward McCarthy, managing director of Stone & McCarthy Research Associates. "These anxieties have to be relieved and a level of confidence has to return for us to get out of this."

The difficulties in the lending market between banks both result from, and can exaggerate, the crisis. The banks from which people are withdrawing money have the greatest need to borrow cash from other firms, yet the breakdown in that lending market makes it all the more likely that they won't be able to get such loans, and thus increase the chances that they fail.

The problem appears to be most severe among European banks. In the United States, bank regulators have been aggressive about engineering buyouts of troubled banks -- most notably Washington Mutual and Wachovia -- without wiping out their lenders.

Meanwhile, the Federal Reserve has taken aggressive steps to try to flood U.S. banks with cash. Last Wednesday, the Fed had $189 billion in loans out to banks for that purpose, and Monday it announced an expansion of those efforts.

"On the domestic side, the Fed has absolutely opened the floodgates," McCarthy said.

But the market for cash among banks is global, and in Europe, government interventions have been unpredictable, with different countries taking different tacks to try to prevent a spiraling crisis in the financial system. Ireland yesterday, for example, effectively put a government guarantee behind its biggest banks for the next two years, while authorities in France, Belgium and Luxembourg injected $9.4 billion into Dexia, a bank that operates in the three nations.

"Does an Italian bank trust a Spanish bank?" asked Albert Kyle, a finance professor at the University of Maryland. "Not as much as a U.S. bank trusts another U.S. bank."

The Fed has also taken novel steps to try to inject dollars into foreign banks, though so far it apparently hasn't been enough to settle the lending environment among them.

Monday, it said it would expand those steps, such that foreign central banks will have access to $620 billion to try to inject dollars into the banks in their respective countries.

© 2008 The Washington Post Company