Banks, which frequently lend each other money, suddenly became aware of counterparty risk, the risk that the other party in a transaction might suddenly go belly up. They began to worry that some bank somewhere might suddenly be unable to secure liquidity and fail. Indeed, on August 9, a liquidity crisis actually occurred, with liquidity drying up quickly in the interbank market.
Many European banks were among those facing liquidity difficulties. Chart 1 shows an unprecedented spike in the three month LIBOR-OIS spread, showing the heightened risk premium in the European interbank market. A liquidity crunch in interbank markets started, and it spread immediately to the United States (Chart 2).