The strange disappearance of the interbank market

Does anyone remember that repulsive line from the early years of new labour - "joined up government"? There might be a need for the Bank of England to consider whether it is operating "joined up monetary policy." Some recent innovations in policy look a tadge contradictory.

Consider the great economic problem of the day - the interbank market. We are told that banks don't want to borrow to each other. It is all too risky, with banks not knowing whether there are other NRKs and B&Bs lurking on the high street.

On the face of it, it seems true. A quick look at the consolidated accounts of the UK banks will show that the volume of interbank lending has fallen dramatically since August 2007. However, if you sit back and ponder on this problem, it becomes a lot more murky.

Think for a moment about supply and demand. If the price of something goes up and the quantity traded goes down, this means that supply has fallen. In the case of the interbank market, the price is the LIBOR interest rate, and the quantity traded is the volume of interbank loans, which is the spare cash that banks are holding on a short term basis.

This raises an interesting question - where did the supply of loans to the interbank market go. In other words, where are UK banks holding their spare cash? Are they sticking it some offshore account abroad. Are they holding the cash in the bank vaults. Where did the interbank market go.

The answer is a shocker. Banks are sticking their spare cash into the Bank of England. Yes, the Bank of England isn't just a central bank, it is a bank to the commercial banks.

On the balance sheet of the Bank of England, there is something called Reserve Balances. These are short term commercial bank deposits. Since the credit crisis, banks have parked their cash there rather than lend to each other.

So, we have the crazy situation of banks complaining about tight liquidity, the Bank of England lending huge amounts of cash to beleagured banks, while at the same time, taking huge deposits of cash from the banking system.

Here is simple idea, why doesn't the Bank of England stop taking deposits from commercial banks and see what happens. Perhaps the banks might take a chance and start lending to each other.