[Source: Institute of International Finance, Washington, DC]

Continuing on the theme of the unusual spread that banks currently have to pay to borrow from each other since August (due to credit risk and liquidity concerns): a Wall Street Journal article on April 16, the day after my last post, explained that LIBOR had recently lost some of its reliability. The true spreads were even higher than what the panels of banks were reporting to the institution that calculates LIBOR, the British Bankers Association (BBA). Banks can have an incentive to act strategically in the interest rates that they report to the BBA. Even though the highest and lowest respondents are dropped from the computation, that was not enough of a correction. But the Wall Street Journal reported the next day that the banks had immediately reacted to this news by increasing the honesty of their interest rate numbers. The updated version of the LIBOR graph exhibits an upturn in the US interbank rate at the very end.

Good news, in that it suggests that LIBOR is again reliable, which matters because many economically important borrowing rates are keyed off of LIBOR. But it is also bad news, in that an increase in the official LIBOR then has a contractionary impact on the real economy — again because so many economically important borrowing rates are keyed off of it. LIBOR has risen about 50 basis points since the last Fed interest rate cut, including 25 basis points in just the last week. It seems likely that the latter rise is the manifestation of the restoration of LIBOR’s truthfulness.

While some aspects of the subprime mortgage crisis were predictable, the freezing up the most liquid risk-free markets in the world was not. The illiquidity has been especially striking in the interbank market. The following chart was kindly made available by the Institute of International Finance, an association of international banks and other financial institutions, in Washington, D.C. Their Capital Markets Monitor reports in April: “Credit and equity markets have recovered somewhat, after a series of central banks’ moves to provide liquidity and safeguard systemic stability. However, tension in term interbank markets remains.”

I see three interesting lessons from the chart.

· The most important one, of course, is simply that the spreads shot up so abruptly last August, and that they remain very high. The have come down twice, most sharply in response to central bank measures in December-January, but they have also relapsed twice. It is extraordinary that even large banks are still so uncertain of their environment that they are reluctant to lend to each other. Not a good sign.

· The second interesting point one might glean from the chart is that each of the three times that the spreads have risen sharply over the last year, the spread in the UK has gone up somewhat more than the Euroland spread, with the Fed somewhere in between. One might use these differences to pass invidious judgment on how well the three central banks have handled the crisis.

· The third point, which dominates the second, is that the correlation across countries is very high. The three lines overall move closely together. This means that even though the interbank market has broken down in an important way that we did not think could happen, the banking system internationally is as tightly linked as ever. Contagion is everything. Even though the problem originated in the US (the sub-prime mortgage crisis last summer), you couldn’t prove it by this graph !