The cost of borrowing dollars, euros and sterling on frozen international money markets jumped on Tuesday, driven by renewed falls in banking stocks, deepening financial turmoil in Iceland and Europe's so-far fruitless efforts to stem the spreading crisis.
The British Bankers Association's daily fixing of London interbank offered rates (Libor) for the three currencies rose across all maturities, from overnight lending out to one year. The premium over anticipated borrowing costs, a key measure of financial market strain, also rose to historically high levels.
Three-month euro Libor was fixed at an all-time high of 5.37125 percent, overnight sterling Libor soared 76 basis points and overnight dollars were fixed at almost double the Federal Reserve's 2 percent target rate. Earlier on Tuesday, the European Central Bank's auction of $50 billion in overnight funds was allotted at a marginal rate of 6.75 percent.
Money market participants said collateralised lending beyond one week was negligible, while there was almost no unsecured lending at all for periods beyond overnight. The latest freeze in the money markets came as shares in Royal Bank of Scotland had plunged as much as 40 percent in the morning, Iceland's financial system sank deeper into the mire and European finance ministers met in Luxembourg to discuss how to respond to the crisis.
"Having major banks down 40 percent isn't going to help money markets without government intervention," said Meyrick Chapman, rates strategist at UBS in London. "It's been clear for at least a week that we need government intervention. Otherwise we are in even more trouble."
At the BBA Libor fixing on Tuesday, Libor/OIS spreads - the difference between Libor and anticipated central bank rates as measured by average Overnight Index Swaps - hit new highs. The widening of these spreads was in part down to the rise in Libor but also down to the growing expectations in financial markets that the US, euro zone and UK central banks will soon cut interest rates, possibly even in unison.
The Reserve Bank of Australia stunned markets on Tuesday, slashing rates by a full percentage point to 6 percent, double the expected degree of easing and the biggest cut since 1992.
The once-a-day Libor fix only shows indicative rates and no necessarily the exact levels banks are lending to each other. But it's a global reference point for trillions of dollars of contracts for financial, corporate and household borrowing.
Even another round of central bank money market operations in Europe on Tuesday, a day after the US Federal Reserve expanded its liquidity provisions, failed to prevent overnight lending rates from rising well above official targets. By and large, lending virtually ground to a halt and calls for more effective policy response across the globe - particularly from Europe - grew louder.
Shares in RBS tumbled following a credit rating downgrade from Standard & Poor's on Monday and rising speculation public funds will be needed to recapitalise the bank. At talks between the UK Treasury and leading British banks late Monday, the injection of public funds into the battered banks was discussed. But RBS on Tuesday denied it asked the government for capital.
The global financial crisis engulfed Iceland, where financial authorities took over the country's second largest bank and the currency plunged but then rebounded on news Russia will provide Iceland with a 4 billion euro loan. The banking sector whirlwind intensified as EU finance ministers met to map out their response, which could include a sharp hike in the minimum levels of deposits guaranteed across all 27 member nations.
"Effective European measures appear as distant as ever. And even if markets would force governments' hands quicker, it is difficult to see how year-end funding may improve. To the contrary," wrote Dresdner Kleinwort strategists in a note. In terms of central bank policy responses to the crisis, however, European monetary authorities acted more firmly.
The European Central Bank and Bank of England offered a combined $60 billion in overnight dollar funds. But reflecting the interbank strains even at the short end, the ECB allotted its $50 billion of funds at a marginal rate of 6.75 percent. The BoE also auctioned 40 billion pounds of three-month funds and the ECB carried out a weekly one-week tender of 250 billion euros.
On Monday, the US Fed offered up to $900 billion in end-of-year lending in a bid to ease term funding pressures. But more than temporary liquidity injections is needed to deliver a lasting reduction in money market rates and spreads. "Ultimately, in spite of the central banks efforts around the globe, it is confidence - not temporary cash injections - in the system that will cure the market's illness over the long run," said Calyon rates strategists in a client note on Tuesday.