While media attention this morning was focused on the slump in share prices an equally significant drama was being played out on the interbank lending markets. The government has rightly identified that it is the crisis in interbank lending that is the most serious immediate problem facing the economy. As the financial media is accurately reporting, banks are refusing to lend to each other and this is reflected in soaring interbank lending (LIBOR) rates. The hope is that by, first, the Bank of England pouring almost unlimited quantities of liquidity into the market and, second, recapitalisation of the banks occurring, interbank lending will commence again.
In fact this analysis is wrong. First the problem is not one of liquidity but one of insolvency produced by falls in the value of assets held by the banks. The banks will not lend because many of their own balance sheets will not permit it and because they fear that the balance sheet of other institutions leaves open the possibility they will not repay any loans given to them.
Regarding the degree of insolvency it is therefore significant that despite the liquidity operations by the Bank of England, the half point interest rate cut, and the promise of capital injections into the banks via government purchases of shares nevertheless LIBOR this morning continued to rise further. This indicates that the market so far calculates that the degree of insolvency is so high it will exceed any promised capital injection - that is, it will not stabilise the banks, opening the risk that a capital injection will take place and share prices will nevertheless continue to fall sharply. This would open the taxpayer to major losses.
The latest data for LIBOR, including today's rate, is shown below.