An interest rate is a supposed to be risk-related

Yesterday overnight Libor was trading at 5.75% whilst 3 month Libor was 6.49%. This difference is largely accounted for by the unwillingness of banks to lend to each over longer periods in the current climate of uncertainty and fear - everyone is scared about what lies below the waterline in terms of potential losses yet to be uncovered/revealed and the possibility of losses on a scale that could massively erode or even eradicate a bank's capital.

So the talk of the Bank of England reducing interest rates to encourage liquidity strikes me as odd. Interest rates are there to compensate for risk and with such fears around, what is the motivation of the banks to charge a lower rate? Default risk in the sector isn't reducing but growing and indeed it seems to now be seeping into the mainstream economy.

Hence, whilst banks may be able to source funds from the Bank of England more cheaply with a rate reduction, unless the Bank is willing to fund the entire inter-bank market by acting as a central counterparty or the like, it doesn't feel like the banks are going to be willing to lend long at cheaper rates.

The Council of Mortgage Lenders Chief Executive also pointed out yesterday that it is a fallacy to believe that the mortgage market can entirely rely on retail funding to support current levels of mortgage lending. Firms like Bradford & Bingley and Alliance and Leicester take 5% and 11% of their funding respectively from the wholesale markets, a pattern repeated elsewhere. Hence the seizing up of the credit market will mean a tightening of lending criteria, higher rates and less funds available for mortgages.

posted by John Wilson @ 10:00 AM Permanent Link newsvine reddit


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