If banks will not lend to each other, global commerce will significantly be curtailed and domestic lending will be substantially reduced. That is the nature of the global banking system today. Arguably, it began when future Citibank CEO Walter Wriston invented the negotiable Certificate of Deposit in 1961, so that banks did not need to depend on their own depositors for lendable funds, and it has expanded into a worldwide interdependency among banks. Over the succeeding years, there have been numerous innovations, many of which, like the creation of bank holding companies, the growth of the commercial paper market, the development of the Eurodollar market, and the emergence of huge non-bank lenders, deserve their own chapters in a book. These developments have not been nefarious, and have been mostly sensible. However, they have created a global interdependency of financial institutions whose downside we are witnessing today. Economist:

the problem. It is widely assumed that central banks set the level of interest rates in their domestic markets. But the rate they announce is the one at which they will lend to the banking system. When banks borrow from anyone else (including other banks), they pay more. Every day, this rate is calculated through a poll of participating banks and published as Libor (London interbank offered rate) or Euribor (Euro interbank offered rate).

Normally, these are only a fraction of a percentage point above the official interest rates. But that has changed dramatically in recent weeks (see chart 1). Take the cost of borrowing dollars. On October 1st banks had to pay 4.15% for three-month money, more than two percentage points above the fed funds target rate…

Bank borrowing costs reached 6.88% on September 30th, more than three times the level of official American rates, while some were willing to pay a remarkable 11% to borrow dollars from the European Central Bank (ECB). Banks have become so risk-averse that they deposited a record €44 billion ($62 billion) with the ECB on September 30th even though they could have earned more than two extra percentage points by lending to other banks. It was the last day of the quarter and, for balance-sheet reasons, banks were particularly keen to have cash on hand. (Overnight rates fell back on October 1st, but one-month rates rose further, indicating that the crisis had not eased.)

In the absence of private-sector lenders to banks, central banks have become vital suppliers in the money markets. With the help of the ECB, the Bank of England and the Bank of Japan, the Federal Reserve agreed to lend a further $620 billion on September 29th…

The money markets’ difficulties began in July 2007, when two Bear Stearns hedge funds revealed the damage done to their portfolios by subprime mortgages. Since August of that year, central banks have been intervening to keep them functioning, with a series of schemes like America’s Term Auction Facility. But the collapse of Lehman Brothers, followed by the long series of rescues in Europe and America, seems to have brought the money markets close to breakdown.

Strong and coordinated measures among governments are needed to get funds flowing again or a disaster will likely happen. We have said that emergency interest rate cuts are needed and appropriate, and Barrons discusses and recommends this as well.

The genie was let out of the bottle around 50 years ago when the nature of bank funding began to be fundamentally changed. Since 1961 the interdependencies among banks and the importance of interbank funding markets has increased immeasurably. There is no going back to the earlier model of funding banks without the gravest of economic consequences. This is an issue of great importance in itself, not to mention its great costliness in our current circumstances. That no one has even thought of proposing devoting a week of one hour daily television programs to explain all this to the people paying the bills, and that the people haven’t demanded it, perhaps says a lot about our politicians, our media, our citizens, and the state of our democracy.

This entry was posted on Tuesday, October 7th, 2008 at 9:03 am and is filed under Democrats, General, Republicans, business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.