Libor rates show banks hoarding cash

By Michael Mackenzie in New York and David Oakley in London

Published: September 22 2008 21:13 | Last updated: September 22 2008 21:13

Equity markets initially greeted Friday’s announcement of the US plan to lift toxic assets out of the banking system with euphoria. But US and European equities fell on Monday, and there were clear signs of strain in other corners of the financial market.

In particular, borrowing rates in the interbank lending market remained high, suggesting it may take some time before banks stop hoarding their cash.

Paul Niven, head of asset allocation at F&C Asset Management, said: “Beyond the short term, where the rot has been stopped, it is our belief that we still have several years of work-out from the credit crunch, as banks rebuild balance sheets, de-leveraging continues, credit is restricted, and the payback for the boom years drags on.”

On Monday overnight lending rates known as London interbank offered rates (Libor) between banks in the dollar, sterling and euro zone markets eased a little further, but they remain above levels seen before last week’s market panic.

In contrast, three-month Euribor climbed 2 basis points to 5.025 per cent, the highest level since 2000 as banks refused to part with their cash. The spread between average overnight rates over the next three months and three-month Euro Libor remained at elevated levels of about 80 basis points. The equivalent relationships in the sterling and dollar markets were also extremely high.

Three-month dollar Libor eased to 3.198 per cent from 3.21 per cent, still well above its 2.82 per cent fix earlier this month.

Ongoing liquidity efforts by central banks and the Treasury bail-out for the banking system should slowly improve the relationship between Treasury yields and Libor, analysts believe.

George Goncalves, strategist at Morgan Stanley, said: “We are seeing a transfer of credit risk from the banking system to the Federal Government and, as a result, the difference between Treasury yields and Libor should slowly meet in the middle”.

The TED spread, which compares three-month Treasury yields and three month dollar Libor, was on Monday trading at 2.28 per cent, down from last week’s record above 3 per cent.

Mr Goncalves said a TED spread trading below 0.90 per cent would reflect normality between Treasury and money market collateral.

As the Treasury keeps selling new bills in order to fund the Fed’s liquidity measures for banks, traders expect yields on bills will steadily rise, after trading near zero per cent last week. In turn the support for bank balance sheets should slowly ease elevated levels in term Libor.

Much, however, rests on money market funds which have sharply pulled back from lending money to banks and companies. This follows last week’s failure of a money market fund for the first time since 1994. Most banks don’t borrow from each other in term Libor as it is usually cheaper to borrow from money market funds.

As of last Thursday, about $320bn of assets had poured out of prime institutional money funds as shareholders moved to preserve their liquidity, said JP Morgan. The bank said: “We would also expect to see at least some of the money that left the prime fund complex this past week, return as the market stabilises.”

The Fed has announced a new liquidity programme for banks to fund purchases of asset-backed commercial paper from prime money funds while the Treasury said it would guarantee the industry. However the $50bn Treasury backing for money funds is a fraction of the $3,400bn held by the sector. Many analysts worry that more redemptions and fund closures beckon and this will keep Libor elevated, particularly until the end of the year, when funding pressure is most acute.

Copyright The Financial Times Limited 2008