We need a market based approach to the credit crisis

We keep hearing that commercial banks will not lend to each other, but that is not quite true. When the crisis started a year ago, spreads in the interbank rose sharply. These higher rates reflected a repricing of risk. Banks were willing to lend to each other but needed higher rates of return in compensation of the increased risk of default.

Central banks were not too keen this market based outcome. Instead, they tried to work around it. The Federal Reserve, the Bank of England, and the ECB cut their policy rates and opened up emergency credit lines at below market interest rates. Over time, these credit facilities have grown and in the post-Lehman world, the outstanding stock of central bank credit has reached astronomical levels.

How does this approach foster interbank borrowing? If the central bank is providing unlimited amounts of credit at extremely low interest rates, what is the incentive for a commercial bank to go to the interbank market and pay a higher rate? In effect, cheap central bank credit has crowded out the private interbank market. Or to put it another way, central banks are offering subsidized credits, and this distortionary price setting has destroyed the interbank market.

If the interbank market is ever to recover, central banks are going to have reduce the amount of credit they offer banks. Otherwise, central banks will become the only source of short-term funding. In fact, this is a reasonable description of the current situation.

The central banks are now stuck in a hole. Despite yesterday's interest-rate cuts, the interbank market shows no sign of recovering. According to Bloomberg, the cost of borrowing in dollars for three months in London soared to the highest level this year. Libor rate for three-month loans rose to 4.75 percent today, the highest level since last Christmas. Remember that the Federal Funds rate is only 1.5 percent. At the same time, and commercial banks are stockpiling huge amounts of cash, which is offering a zero rate of return, while other banks are borrowing cheaply from the central bank.

Perhaps a more sensible strategy would be for the central banks to offer unlimited credit lines at interest rates fractionally above the market determined interbank rate. This would encourage banks to return to the interbank market.

Slowly but surely, we would see the market return to normal as banks regain confidence in each other. Any bank deemed an unacceptable risk could still get credit from the central bank, thus preventing a bank run. Moreover, if a bank continued to seek central bank credit, this would be a powerful signal that the bank needed something more than just a credit line, like for example, a capital injection, or even full nationalization.

Without a market-based approach to this problem, central banks will be trapped in a permanent funding crisis, with banks begging huge amounts of low cost credit.