The Fed had announced a significant expansion of its liquidity support operations even before the Bear Stearns crisis broke. By contrast, aside from minor fine-tuning, the facilities offered to UK banks by the Bank of England have remained unchanged despite a steady climb in interbank rates in recent weeks, with three-month LIBOR fixing yesterday at 5.98%.

The Bank’s inertia reflects a view that interbank rates are rising because of heightened concern about counterparty credit risk rather than a shortage of liquidity. This is illustrated by a chart on page 11 of the latest Quarterly Bulletin (page 13 of the PDF), purporting to show that the liquidity or non-credit premium in current term spreads is negligible. Bank officials are therefore sceptical that expanding money market operations would have much impact; their inaction may also be informed by Mervyn King’s view that markets were previously underpricing risk so rising credit premia should not be resisted.

The flaw in this analysis is that credit risk and illiquidity are inextricably linked, as Paul De Grauwe argues on page 13 of today’s Financial Times. Northern Rock was and is solvent but its liquidity crisis resulted in significant losses for holders of its more junior debt. Market concerns that selected institutions will be unable to obtain funding are likely to have resulted in credit risk premia overshooting levels implied by solvency considerations.

Bank chiefs are reportedly meeting with Mervyn King today to ask for an expansion of liquidity support. That they have been forced to lobby publicly for such action suggests the Bank of England remains out of touch with markets and has failed to learn the lessons of Northern Rock.