Credit Market Freeze – Causes and its Importance

The sub-prime mortgage crisis and the credit freeze are often spoken about in the same breath. In fact, the layman would believe that both these words actually refer to the same event. However, that is not the truth. The subprime mortgage crisis played out in the bond markets whereas the credit freeze played out in the interbank lending markets. They two may have been related. However, both of them are mutually exclusive events.

In the previous articles, we have studied all about the subprime mortgage crisis. In this article, we will look at the details of what caused the credit freeze and why was it important?

Interbank Markets

Banks are required to maintain a certain amount of reserves on hand with the Central Bank. In return, the Central Bank is required to bail out individual banks as well as the banking system in case of unforeseen events like a run on the banks.

However, as the banks conduct their business of day to day borrowing and lending, it is unlikely that they will always have the exact number to meet the reserve requirements. The banking system as a whole will have the exact reserve requirements. However, individual banks may not have the requisite amount of reserves. Hence banks trade reserves with each other in a market known as the interbank market.

As the name suggests, this is basically a market where banks make unsecured loans to other banks. The tenure of these loans varies from overnight to a few days. This market is the backbone of the modern fractional reserve banking system and any issues in the interbank markets always have large scale implications. This was the case with the credit freeze of 2008.

Uncertainty Post Lehman Brothers

The interbank lending market is made up of banks that are willing to lend to other banks. The lending is primarily unsecured. This means in case of Bank A making a bad loan to Bank B and bank B collapsing, Bank A simply has to write down the loans given in the interbank market i.e. they do not have any recourse.

In 2008, the days after the fall of Lehman Brothers fall, there was a credit freeze. The reason behind this is simple. Lehman Brothers was a massive bank and had dealings with all other banks in the United States and across the world.

Hence, when Lehman Brothers collapsed, all the firms that were left holding Lehman’s debt were not going to be paid. There was therefore increasing suspicion amongst the banking community regarding lending to other banks. What if the other bank held a significant amount of Lehman debt and was never going to be paid? What if the other bank collapsed? Hence, the Lehman Brothers collapse brought about a situation wherein banks were simply not lending to other banks in the interbank market. They were uncertain about the balance sheets of the other banks and knew that they would end up undertaking excessive risk. Since no one was lending credit and liquidity all over the world froze.

The Effect of the Freeze

The effect of the freeze on the banking system was catastrophic. Firstly, it became known to the public that the banking system was in jeopardy. The bankers did not trust each other, so then how could they expect the individuals to trust them with their money. As a result, there were old fashioned runs on the bank and some institutions were simply bankrupted.

Apart from that, the banks were unable to find enough liquidity for their functioning. Unless they were able to generate more funds, their loan making capabilities were hindered. Usually, they would just borrow the shortfall from the interbank market. However, of late the interbank markets had simply frozen.

Central Banks Intervene

It took central bank intervention to break this standoff credit freeze between the member banks. The European Central Bank and the Federal Reserve realized the gravity of the situation. They also understood that unless action was immediately taken, more problems would arise.

As a result, the Central Bank of Europe pumped billions of euros into the interbank market on its own. When banks were not willing to lend to one another, the Central Bank was willing to take the risk on its member banks. Seeing the situation stabilize in Europe, the Federal Reserve also followed suit and pumped in billions of dollars into the US interbank market. Once again, the Fed was willing to take the counterparty risk. As a result of this intervention, the credit freeze was eliminated.

The Fed and European Central Bank had succeeded in temporarily kick-starting the market. However, they did not want to be making loans in the long run. In the long run, they wanted the banks to be lending out money to each other. Therefore to induce this behavior and end the credit freeze, the Fed and the ECB cut the repo rate by a few basis points. As a result, the banks started lending out money to other member banks.

Systemic Risks

The credit freeze of 2008 brought to light the systemic risk faced by the entire financial world. If the crisis had been a little bit more grave and the Central Banks, a little less prepared, the world would have seen a much bigger financial disaster. Since the 2008 crisis was mitigated, major banking regulators of the world are trying to create a system in which such a credit freeze scenario never plays out again.