Why have interbank interest rates climbed sharply in recent weeks? The conventional view is that the increase reflects heightened concern about counterparty risk, partly due to the Bear Stearns crisis. However, an alternative explanation is that banks have exhausted the longer-term liquidity support provided by the Bank of England in tandem with other central banks around the turn of the year and are again scrambling to secure funding in the interbank market. This would suggest a need for a further expansion of such “lender of last resort” operations – a possibility now reluctantly being considered by the Bank of England.

The alternative explanation is supported by evidence that UK banks have continued to securitise and off-load loans in large volumes in recent months. According to Bank of England data, £29 billion of securitised lending to the UK private sector was removed from balance sheets in the seven months from August to February – only modestly down from £37 billion in the first seven months of 2007, before the financial crisis broke (see chart). Market demand for such paper has been non-existent since the summer. Instead, the securities are likely to have been used as collateral to obtain longer-term funding from the Bank of England and ECB.

The Bank maintained a strict definition of eligible collateral in the early stages of the crisis but relented to market demands and accepted triple-A-rated asset-backed securities in auctions to allocate £20 billion of three-month funds in December and January. This allowed banks to off-load their securitised paper and contributed to a sharp fall in term interbank rates in the first few weeks of the year. However, the relief has proved temporary as credit expansion has remained robust in early 2008, further boosting banks’ funding needs. The Bank is rolling over the December / January facilities but has not yet announced an increase in their size.

The gap between the £29 billion of securitised loans removed from balance sheets between August and February and the current £20 billion Bank of England limit on ABS collateral supports claims that UK banks have also been accessing ECB funds, either via Eurozone subsidiaries or by arrangement with facilitator banks. Indeed, the ECB may have been the first port of call given that it accepts collateral rated down to single A as long as securities are senior within the credit structure.

If the above explanation is correct, the Bank of England faces a difficult choice in responding to current market pressures. It can follow the recent example of the Federal Reserve and expand support operations significantly; as in December / January, this would probably be effective in lowering interbank rates but at the cost of a semi-permanent increase in banks’ reliance on official funding and associated “moral hazard” risks. Alternatively, it can refuse to bridge the funding gap created by continued solid lending growth, forcing banks to restrict credit availability further, with possibly major negative economic implications. In theory, the impact could be offset by cuts in official interest rates but achieving the right balance would be problematic, particularly against the backdrop of above-target and rising inflation.