Market Volatility and Interbank Lending

The markets have been taking a wild ride these past few weeks. Those of you who crave volatility must be having a field day however; one can’t help but be puzzled as to what’s causing the recent market swings.

We know that the roots of the current financial crisis lie in the securitization of sub-prime mortgages and a general failure in containing risk within these portfolios. We know that there are significant funds being made available to the financial institutions to make loans as well as to purchase toxic assets off the balance sheets of these institutions. So why all the uncertainty and when will recent measures actually bring stability to the markets?

Banks form the base of the economic pyramid given that businesses depend on them for loans for various projects that otherwise would not be carried out. At the end of the day, banks make money from these transactions and have typically relied on the ability to borrow from each other should they experience a shortfall of cash reserves at the end of each business day. The recent revelation regarding financial institutions with unprecedented levels of toxic assets on their books has resulted in a disintegration of trust among banks. This has caused banks to start hoarding cash instead of freely lending to each other.

Interbank lending rates such as LIBOR can be used as a rough proxy for the measure of trust between banks. Despite cuts of the benchmark lending rates by the Federal Reserve and the Bank of Canada, LIBOR has jumped to the highest levels since December of last year. In other words; banks do not trust each. After all, without clarity on how these assets will be divested, they could end up lending money to insolvent institutions. Furthermore, banks have no reason to believe that borrowing banks will no longer engage in the activities that got everyone in this mess to begin with. To the best of my knowledge, there has been no notable change in regulations, executives or boards of directors at any of the offending institutions. Perhaps there is a concern that any such move would be interpreted as an admission of wrongdoing. In any case, it is unclear when banks will free up capital and when business will have access to prior levels of debt financing. While this is the case, I am not sure that we can expect stable markets anytime soon.

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