And progress on guarantees, while gradual, has also been encouraging, with a number of banks issuing bonds even without the use of the guarantee. Libor spreads have also edged down and are now expected to fall a bit further and faster than before the package (Chart 8). Many banks continue to face a period of deleveraging and rebalancing to reduce their dependence on Central Bank finance and on short term wholesale funding. However a stronger capital and financing position will make it possible for them to do that over a period of some years, which will diminish the squeeze on lending in the short run. More widely, of course, the financial system remains under acute strain. The falls in equity markets, corporate bond prices and the prices for leveraged loans is hitting both long term institutional investors and leveraged investors, including hedge funds. Some are being forced to sell into a falling market in response to margin calls and redemptions. BIS Review 132/2008  3  And there are growing signs of stress in many emerging market economies. We have already seen a banking sector and currency crisis in Iceland and in the past few days the IMF has also announced loan packages for the Ukraine and Hungary. In short, the package of measures introduced in the UK and elsewhere has improved the prospects significantly, especially for banks but it is too soon to declare the crisis over. Authorities worldwide need to remain vigilant and to be ready to step in again if necessary.
The focus of their concerns shifted from future profitability to future survival. CDS premia rose to unprecedented levels (Chart 6), bank equity prices fell sharply and the money markets seized up. Interbank lending spreads widened dramatically (Chart 7) and lending became almost entirely concentrated in the overnight market. The shortening of interbank maturities generated a dangerous “snowball” effect as maturing term funding had to be rolled overnight. It was to tackle that wider loss of confidence that the UK authorities announced on 8th of October its comprehensive package of support for recapitalisation, guaranteed funding and enhanced liquidity. It was designed to remove solvency fears by ensuring that banks had more than sufficient capital to survive a severe economic downturn and thus to enable them to continue to lend on normal criteria to good credits. The new capital and the government guaranteed borrowing and liquidity support was designed to ensure and be seen to ensure that banks would be able to sustain their businesses through a downturn. With the banking system fully solvent, guarantees could be extended without exposing taxpayer to unacceptable risks. In a remarkable show of international consensus, a similar approach was quickly adopted by many other countries both in the US and EU and more widely. Looking ahead The early signs suggest that the package is underpinning the banking system both directly and as a demonstration of the authorities’ determination to do whatever is needed to reestablish confidence. In particular CDS premia for banks have fallen markedly (Chart 6) since the package was announced.