Short-term interest rates rise again, as tight credit conditions continue

Posted Oct 9th 2008 10:30AM by Joseph Lazzaro
Filed under: International Markets, Federal Reserve, Financial Crisis

The slowdown in global credit markets continues. Interest rates for three-month loans in dollars continued to rise early Thursday, as a coordinated interest rate cut by the world's major central banks failed to jump-start bank-to-bank lending.

Credit markets: Freeze frame

The London three-month rate for dollar loans increased 23 basis points to 4.75%, Bloomberg News reported Thursday. Meanwhile, the London interbank offered rate, or LIBOR -- the rate banks charge each other for overnight dollar loans -- decreased 29 basis points to 5.09% early Thursday morning; nevertheless, the level still is a very high rate for short-term cash.

Overnight rates are key sources of cash for corporations and other large institutions, which use the cash to pay suppliers, make payroll, roll over debt etc. Hence, a very high overnight will discourage corporations from conducting business, restricting commerce and slowing the economy, economists say.

Economist Peter Dawson told BloggingStocks Thursday the failure of short-term, bank-to-bank rates to drop indicates that monetary and fiscal officials will have to do more to maintain financial system liquidity. "Banks remain in a state of fear. Basically, the way things are now banks are assuming that their competitor banks are insolvent unless proven otherwise," Dawson said. "It's a breakdown in trust and its constricting commerce. If it continues it's going slam GDP on both sides of the Atlantic."

Dawson said in addition to the U.S. Treasury's purchase of distressed and bad assets to remove them from the system, the U.S. Treasury and comparable departments in Europe will have to recapitalize selected banks.

"It's a necessary step because the current system is at least frozen if not broken," Dawson said. "Banks have cash but uncertainty and fear are causing them to sit on it. If the current banks don't lend, they have to be recapitalized, or new banks have to be created."

On Wednesday, the United Kingdom announced that it would recapitalize banks with 50 billion pounds or about $87 billion, Bloomberg News reported Thursday. Dawson said the U.S. should implement a similar plan, concentrating on those solvent, viable banks that can provide the greatest amount of overnight and related, short-term money access.

Monetary Policy & Economic Analysis: A recapitalization of U.S. banks appears to be the next, likely step to loosen credit markets and lower short-term interest rates. Economist Dawson also recommended another tack: a temporary insurance provision by the Fed guaranteeing repayment to any bank who sustains a loss after lending overnight and short-term funds.

Tags: banking sector, banks, bond market, credit markets, Fed, gdp, interest rates, inthenews, LIBOR, U.S Federal Reserve, U.S. Treasury, United Kingdom