Banks are hoarding their own cash because they fear they may have to fund other loans or assets unexpectedly (photo: Paul Richards/AFP/Getty Images)
GLOBAL FINANCIAL STABILITY REPORT
Banks are not lending to other banks, except at very short maturities, worried about whether their counterparties are likely to remain in business. They hoard their own cash, because they fear they may have to fund other loans or assets unexpectedly and may find it difficult to obtain interbank funds in the current situation, which may in turn be interpreted as a weakness by market participants. These dislocations not only raise bank funding costs, but have affected other funding markets and the interest rate channel of monetary policy transmission.
Rates are key benchmarks
The rates on uncollateralized interbank loans, such as the London Interbank Offered Rate (LIBOR), are benchmarks for a significant number of financial derivatives instruments—especially interest rate derivatives, of which an estimated $400 trillion in outstanding principal are LIBOR-related. And many commercial and even consumer interest rates are linked to interbank rates such as LIBOR, which is a consensus of estimates by a number of British banks of their expected unsecured borrowing costs in various maturities and a variety of currencies.
A special analytical chapter in the GFSR identifies two issues as key determinants of elevated bank funding rates:
• Distress risk, the combination of liquidity and credit risks facing banks,
• U.S. dollar liquidity pressures—the availability of dollars for financial institutions abroad with dollar funding needs, a particularly important issue in European money markets.
Monetary policy transmission
The dislocations in the interbank market also appear to have had serious effects on the interest rate transmission of monetary policy, especially in the United States, according to the special analysis in the GFSR, which was released October 7. Interest rate transmission of monetary policy occurs when central banks adjust policy rates, typically an overnight rate such as the U.S. federal funds rate, and these changes feed through to interbank and money market rates. In turn, those rates influence consumer and business lending rates and, ultimately, domestic demand, output and prices.
Although structural changes in the financial sector over the last 25 years had little effect on this mode of transmission of monetary policy, the evidence presented in the report suggests that there has been a significant disruption in elements of interest rate transmission since the summer of 2007 when the financial crisis began. The IMF cited the growth of near banks (such as finance companies, securities firms, and other similar financial institutions); increasing bank reliance on wholesale rather than interbank funding; and the shortening of liabilities of banks and nonbanks as among the possible sources disrupting policy rate transmission.
Dealing with disruptions
To deal with money market disruptions and interest rate transmission problems, the IMF made several recommendations. Among them:
• Policies should jointly address credit and liquidity pressures, which, though theoretically different, are virtually indistinguishable under current conditions. Central banks should continue to provide liquidity support, but solvency concerns also need to be addressed. Regulators and supervisors should act to reduce uncertainty about credit risks by requiring standardized reporting of off-balance sheet items and increased disclosure about the valuation of collateral and the liquidity practices of major financial institutions.
• Central banks should have a broad mandate and strategy to take measures to restore the functioning of markets that are necessary for smooth interest rate transmission of monetary policy.
• To be effective in increasingly globalized world financial markets, central banks and regulators worldwide need to share information and cooperate more closely.
Comments on this article should be sent to imfsurvey@imf.org
