Getting the interbank market going again: the central bank as counterparty of last resort

The interbank markets, secured and unsecured are, respectively, moribund and dead. The reason banks don’t lend to each other in the interbank market is counterparty risk – fear of default of the party they are lending to.  Unsecured interbank lending (for which Libor or Euribor are common price measures) has effectively vanished, even at the overnight maturity.  Secured interbank lending only occurs against very high-grade collateral and mainly for short maturities.  It is quite possible, indeed likely, that unsecured interbank lending will not return on any significant scale – ever.  In that case, Libor and Euribor would have to be replaced as benchmarks for pricing other private lending, by secured interbank lending rates, such as the OIS rate.

When banks don’t lend to each other, they are also unlikely to lend to economic agents that matter intrinsically: households and non-financial corporations.  This has been a problem for a while in the US and the UK as regards bank lending to households, to developers and to firms in the construction sector. It is now spreading rapidly, in the US, the UK and in the rest of Europe, to the non-financial sector as a whole, starting with SMEs, but not stopping there.

To get interbank lending going again, banks must have confidence in each other’s solvency and liquidity.  How can we restore trust in these interbank relationships?  There are a number of options.

  1. Nationalise the banks.  When they have a common majority owner (the state), the state can simply instruct the banks to lend to each other.  Problem solved.  It may come to that in any case, but for those who are not ready for such measures, here are a couple more.
  2. Guarantee interbank lending.  Here the Treasury guarantees interbank transactions, both secured and unsecured.  This should be done against fees that ensure the Treasury an acceptable risk-adjusted rate of return on this activity.
  3. Have the central bank interpose itself as the universal counterparty for interbank transactions.  This is effectively already the case in the overnight market in the UK and the euro area.  When the Fed starts paying interest on reserves (commercial bank deposits with the Federal Reserve System), we will see the same phenomenon there.  In the UK, for instance, banks hold large deposits overnight with the Bank of England at the standing deposit facility (which pays 100 basis points below Bank Rate (the official policy rate) )and borrow either by running down these overnight deposits or by borrowing overnight at the standing lending facility (at a rate 100 basis points above Bank Rate).  The same phenomenon can be observed with banks in the euro area.  That 200 basis points spread (between the standing deposit and standing lending facilities rates) is hefty, but banks prefer it to taking the counterparty risk of other banks, even overnight.  Instead of commercial banks A and B lending directly to each other at longer maturities than overnight, bank A could lend to the Bank of England, and the Bank of England could then on-lend to bank B, more or less ‘on demand’.  This would require the Bank of England  to take a view of what the interbank rate ought to be at all the maturities where it acts as the universal counterparty of last resort – something it has been loath to do.  It could do this either for unsecured transactions or for both secured and unsecured transactions.  The spreads and other fees associated with this counterparty of last resort role would vary with the maturity of the loan, the quality of collateral, and the Bank of England’s assessment of the creditworthiness of the banks borrowing from it.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website