Credit Thaw Is Spurring Appetite for Bank IOUs

By CARRICK MOLLENKAMP, NEIL SHAH AND STEPHEN FIDLER Investors have developed a voracious demand for short-term debt issued by U.S. and European banks, and an important global lending benchmark has fallen to an all-time low -- welcome signs that bank credit markets have improved. But beneath the demand for short-term bank debt, known as commercial paper, and a drop in the London interbank offered rate, or Libor, significant kinks remain lodged in the bank markets: Banks are using the fresh cash to repay existing debt, or simply hoarding it. That cash buildup is potentially stymieing efforts by regulators to circulate funds to borrowers and the most needy banks. In contrast to the panicked days early this year, bank commercial paper "flies off the screen," said one New York trader. The market for this short-term bank debt runs from 7 a.m. to about 2 p.m. in New York. But investor demand has been so strong that some banks are turning away buyers by late morning. Commercial paper is short-term IOUs issued to raise money for short periods. Libor reflects the rates at which banks can borrow at maturities ranging from overnight to one year. The rates are calculated daily in London when a panel of banks report their borrowing costs. In recent months, Libor has fallen sharply, reflecting a broader thaw as investors' confidence in the financial system returns. As of Wednesday, three-month dollar Libor stood at its lowest level on record: 0.4875%, down from 4.81875% at the peak of the crisis in October. Meanwhile, one measure of risk in the banking system -- the difference between three-month dollar Libor and the U.S. Federal Reserve's expected target rate -- is approaching 0.25 percentage point, a level that former U.S. Federal Reserve Chairman Alan Greenspan once said would signal the end of the financial crisis. The fact that central bankers are providing cheap money has lessened the value of Libor. 'Return in Confidence' There is the possibility that three-month dollar Libor could fall yet further. The most healthy U.S. and European banks are selling three-month commercial paper at a range of 0.3 percentage point, or nearly 0.2 percentage point below the three-month Libor, according to one New York desk that trades commercial paper. That suggests Libor might fall further if it tracked the cost of selling the short-term IOUs. "You've got a return in confidence," said Joseph Abate, money-markets strategist at Barclays Capital. That is good news for banks as well as borrowers. Libor is used as a benchmark for interbank loans as well as for borrowings for homeowners and credit-card borrowers. Separately, the gap or difference between three-month and one-month dollar Libor has shrunk, a sign banks are willing to lend to one another for more than a month. Historically, that gap has been zero. Yet Libor's fall mightn't be a sign banks have restored confidence in one another. Rather, it is that emergency central-bank programs have stabilized the markets that make up the plumbing of the global financial system. Last month, the European Central Bank lent banks in the euro zone some €442 billion ($626 billion) in one-year loans, at the ECB's key rate of 1%. Demand for the ECB's cash was heavy, a sign Europe's banks may still be having trouble funding their businesses. Euro Parking What is more, European banks are parking tens of billions of euros at a deposit facility maintained by the European Central Bank. In the past week or so, banks have deposited between €170 billion and €195 billion at the ECB, according to ECB data and Morgan Stanley. That is a clear sign "euro area financial markets are not distributing cash to the interbank and nonfinancial markets as well as they might be," Morgan Stanley interest-rate strategist Laurence Mutkin said in a report, adding, "Only a fall in use of the deposit facility would demonstrate banks' willingness to lend rather than hoard cash." An ECB spokesman declined to comment on the report. All these factors have created an odd market dynamic: Banks are increasingly flush with cash. But they are choosing not to lend it, and borrowers are opting not to seek funds. Alistair Darling On Wednesday, the Bank of England and the ECB separately reported that Europe's banks remain leery of lending despite massive government aid and pressure from officials such as U.K. Treasury chief Alistair Darling and ECB President Jean-Claude Trichet. On Monday, for example, Mr. Darling called in the heads of the U.K.'s seven largest banks and urged them to step up lending to small- and medium-size firms. In the U.S. and Europe, one problem is a lack of actual borrower demand, especially as consumers and companies themselves seek to reduce their debts. In a speech Wednesday, New York Federal Reserve President William Dudley said banks are still working through large credit losses and that the market for offloading loans to investors remains limited. "This means that credit availability will be constrained for some time to come, and this will serve to limit the pace of recovery," Mr. Dudley said. Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com