Three months is a long time in financial markets. That’s roughly how long it has taken for a global liquidity flood to turn into its reverse—markets in which it’s hard to get even low-risk transactions done. And right now, three months looks long in another sense: it is too long for lenders to commit themselves.
Thanks to extensive support from central banks, overnight loan markets are now functioning. But reports from the three-month trenches are pretty grim. Interest rates on loans between banks, the Libor rate, are 75 basis points higher than the risk-free overnight rate. In normal times, this spread is around 10 basis points.
Three-month spreads have widened in the last week. Worse, these elevated rates have not been enough to get business flowing. There are few transactions, even in paper without any apparent taint from troubled US subprime mortgages.
There are two closely related problems. First, banks are short of short-term funds to lend. Non-bank short-term lending, particularly in the commercial paper market, is in rapid decline—$200 billion of the $1,400 billion assets in conduits have disappeared in three weeks. Banks have had to take up the slack.
Second, banks are afraid to lend out the funds that they do have. They don’t want to be caught out if markets become still more illiquid, or if liquidity problems cause apparently strong intermediaries to default.
Of course, when many banks make sensible decisions to conserve their own liquidity, the effect is to reduce the availability of funds for whole system. In turn, the liquidity squeeze accelerates the rush out of commercial paper and increases the incentive for individual banks to hoard cash. These are the pains that come with massive deleveraging. They don’t seem to be going away.
Technically, illiquidity is never an insoluble problem in a financial system based on fiat money. Central banks can just make more of the stuff, trading it for any asset that cannot otherwise be sold. The authorities may not like the effective nationalisation of risk that comes with taking on three-month paper. But the alternative probably looks worse.