Worry About The Credit Crisis

What is the most important part of a house? Is it the garden, the living room? Maybe it's the kitchen. Actually, it is the electrical wiring and the plumbing - the bits you cannot see. So it is with financial markets. The stockmarkets are the most visible part of the system. The money markets, however, are the plumbing of the system. Normally, they function efficiently, allowing investment institutions, companies and banks to lend and borrow trillions of dollars. They are only noticed when they go wrong. And, like plumbing, when they do get blocked, they make an almighty mess.

First, the problem. It is widely assumed that central banks (The Reserve Bank of India, for example) set the level of interest rates in their domestic markets. But the rate they announce is the one at which they will lend to the banking system. When banks borrow from anyone else (including other banks), they pay more. Every day, this rate is calculated through a poll of participating banks and published as Libor (London Interbank Offered Rate) or Euribor (Euro Interbank Offered Rate). Normally, these are only a fraction of a percentage point above the official interest rates.

In the last few months the spread between the Libor and the Fed Funds Rate has widened to almost 200 bps(basis points). The width of the margin reflects investors’ worries about the strength of the banks. Three months is now a long time to trust in the health of a bank. In addition, banks are anxious to conserve their own cash, in case depositors make large withdrawals or their money gets tied up in the collapse of another bank, as with Lehman.

Why do these markets matter? First, the rates on loans paid by many consumers (floating rate home-loans, for example) and companies are set with reference to the money markets. Higher rates for banks mean higher rates for everyone. Second, if the markets are blocked for more than a week some companies may find it hard to get any finance at any price. That could mean more bankruptcies and job losses. Third, more banks could go bust if the blockage continues, making investors even more risk-averse. The downward spiral would worsen.

Deprive a person of oxygen and he will turn blue, collapse and eventually die. Deprive economies of credit and a similar process kicks in. So it is safe to say that, until the money markets behave more normally, the financial crisis will not be over. And until the financial crisis is over, the global economy may not recover.