London banks hoard cash as liquidity crunch worsens


Sense of Growing Crisis over Interbank Deals

By Gillian Tett
Financial Times, London
Tuesday, September 4, 2007

As bankers have returned to their desks this week after the summer break, they have been searching frantically for signs that the markets are gaining a semblance of calm after the August turmoil.

However, the money markets are notably failing to offer any reassurance. While the tone of equity markets has calmed, the sense of crisis in the interbank markets actually appears to be growing -- especially in London.

In particular, the cost of borrowing funds in the three-month money markets -- as illustrated by measures such as sterling Libor or Euribor -- is continuing to rise, suggesting a frantic scramble for liquidity among financial groups.

This trend is deeply unnerving for policymakers and investors alike, not least because it is occurring even though the European Central Bank and the US Federal Reserve have taken repeated steps in recent weeks to calm down the money markets.

"What is happening right now suggests that the moves by the Fed and ECB just haven't worked as we hoped," admits one senior international policymaker.

Or as UniCredit analysts say: "The interbank lending business has broken down almost completely. ... It is a global phenonema and not restricted to just the euro and dollar markets."

If this situation continues, it could potentially have very serious implications.

One of the most important functions of the money markets is to channel liquidity in the banking system to where it is most needed.

If these markets seize up for any lengthy period, there is a risk that individual institutions may discover they no longer have access to the funds they need.

This danger has already materialised for vehicles 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.

As Axel Weber, a member of the ECB council, admitted this weekend: "The institutions most affected currently are conduits and structured investment vehicles. ... Their ability to roll these short-term commercial papers is impaired by the events in the subprime segment of the US housing market."

This problem is affecting the wider banking system because these vehicles are now tapping other sources of finance -- mainly liquidity lines from banks.

It appears that the prospect of receiving new liquidity demands has prompted banks to rush to raise funds -- and, above all, hoard any liquidity they hold.

The high demand from banks to secure liquidity for the next three months, coupled with their desire not to lend out what liquidity they have, have made it virtually impossible to execute trades -- even at the official prices quoted for such borrowing.

That has created some extraordinary dislocations such as the fact that the cost of borrowing three-month money in the sterling Libor markets is now higher than borrowing six-month or 12-month money. "The system has just completely frozen up -- everyone is hoarding," says one bank treasurer. "The published Libor rates are a fiction."

This situation could become increasingly dangerous in part because many other markets, such as swaps, are priced off the three-month Libor and Euribor rates. So the interbank freeze could have knock-on effects throughout the financial system.

A more pressing problem is the large volume of asset-backed commercial paper due to expire in coming weeks, which is set to increase the scramble for cash by the banks. "Money-market stability needs to return as soon as possible," says William Sels of Dresdner Kleinwort. Jan Loeys of JPMorgan, notes: "The longer it lasts, the greater the risk that the current liquidity crisis will worsen."

The crucial uncertainty is what, if anything, policymakers can do to combat the sense of panic. Some observers hope the problems in the sterling market, at least, may dissipate when the current maintenance period at the Bank of England comes to an end.

Others, such as Mr Weber, have suggested that banks themselves need to raise more funds in the capital markets to meet liquidity calls. However, many private-sector bankers, for their part, say that radical steps from 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.

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