Is Liquidity Enough?

Every week brings more injections of liquidity into the global banking system by the US Federal Reserve and the European Central Bank. But healthy spending and production no longer depend only on the soundness of the banking system and public confidence in its stability.

Every week more liquidity is injected into the global banking system by the United States Federal Reserve and the European Central Bank. The average interest rate paid for overnight reserves in the US has been well below the 5.25% per year that the Fed still publicly says is its target.

But the market for overnight reserves now appears to be divided into three segments. Banks known to be healthy can borrow at much less than 5.25%. But banks facing possible liquidity problems – which the Fed wants to be able to borrow at 5.25% – are borrowing from the Fed itself at 5.75%, as are a few big banks that want more liquidity but don’t believe they could get it without disrupting the market.

Such a difference in the prices charged to “regulated banks” in financial markets is a sign of a potential breakdown. To date, the premiums charged are small: for an overnight loan of $100 million, even a one-percentage-point spread in the interest rate is only $3000. That reflects the small probability that the market is assigning to the occurrence of a full-blown financial crisis with bankruptcies and bank failures. In normal times, however, there is no such premium at all.

To continue reading, register now.

Subscribe now for unlimited access to everything PS has to offer.


As a registered user, you can enjoy more PS content every month – for free.