Local Business Lending Depends on Ready Access to Liquidity
Without access to the interbank lending market, local banks are reluctant to extend business credit lines. The reason was explained by economist Ronald McKinnon in a Wall Street Journal article in May:
Banks with good retail lending opportunities typically lend by opening credit lines to nonbank customers. But these credit lines are open-ended in the sense that the commercial borrower can choose when - and by how much - he will actually draw on his credit line. This creates uncertainty for the bank in not knowing what its future cash positions will be. An illiquid bank could be in trouble if its customers simultaneously decided to draw down their credit lines.
If the retail bank has easy access to the wholesale interbank market, its liquidity is much improved. To cover unexpected liquidity shortfalls, it can borrow from banks with excess reserves with little or no credit checks. But if the prevailing interbank lending rate is close to zero (as it is now), then large banks with surplus reserves become loath to part with them for a derisory yield. And smaller banks, which collectively are the biggest lenders to SMEs [small and medium-sized enterprises], cannot easily bid for funds at an interest rate significantly above the prevailing interbank rate without inadvertently signaling that they might be in trouble. Indeed, counterparty risk in smaller banks remains substantial as almost 50 have failed so far this year.
The local banks could turn to the Fed's discount window for loans, but that, too, could signal that the banks were in trouble; and for weak banks, the Fed's discount window may be closed. Further, the discount rate is triple the Fed funds rate.
