Interest rates are cut, yet banks put rates up! Is the credit crunch set to continue?

Setting interest rates is one thing the Bank of England can do to influence the banking system (the other is pumping billions of pounds into the system).

The Prime Minister has been dropping hints that a rate cut wouldn’t go amiss – suggestions that were condemned by the Tories as threatening the bank’s independence.

Today the Monetary Policy Committtee cut interest rates by 0.25% – but some banks had already announced they were raising interest rates.

As for doling out the dosh:

UK banks seek more BoE borrowing
By Norma Cohen and Jane Croft in London and Michael Mackenzie in New York
Published: April 10 2008 03:00 | Last updated: April 10 2008 07:41

The Bank of England fears that the credit crisis has entered a new and more serious phase as British banks on Wednesday took steps to increase their borrowing facilities with the central bank to insulate themselves from another lending panic.

UK banks asked to increase sharply the reserves they hold on deposit at the Bank this month to the highest ever level amid concerns that the instability of the banking system could suddenly leave them desperate for cash. They fear another bank crisis – akin to the collapse of US investment bank Bear Stearns – could see the market seize up.

Banks have asked to keep total reserves of £23.54bn on deposit that they can borrow to meet short-term financing needs if they cannot borrow in the interbank market. This is up from the nearly £20bn they had on deposit until yesterday. This is money the banks keep on deposit at the Bank, earning interest, but that they can access when the cost of borrowing from other banks becomes too high.

The Bank did not comment publicly. But it is understood that senior Bank officials believe that UK markets face a further period of mounting problems, in spite of some recent comments suggesting the worst of the liquidity squeeze may be over.

In the aftermath of the rescue of Bear Stearns by JPMorgan Chase, backed by the US Federal Reserve, money markets tightened further on fears that another bank might collapse.

Yesterday, money markets in the US and Europe were signalling renewed fears about the financial strength of banks, with key confidence barometers almost returning to levels that preceded the fate of Bear Stearns.

The concerns are being highlighted by the difference between overnight lending rates set by central banks and three-month Libor, the rate at which banks lend to each other.

This spread, known as the overnight index swap rate, has been rising in the US and remains elevated in Europe, indicating that banks are reluctant to lend to each other.

“Libor is still dysfunctional and, for whatever reason, banks still appear unwilling to lend funds,” said Dominic Konstam, head of interest rate strategy at Credit Suisse.

Meanwhile, there are signs that banks are now taking into account the risks of lending to homebuyers with deposits of only 5 per cent of the purchase price. For these buyers, a small downturn in house prices could tip them into negative equity, leaving lenders with collateral worth less than the outstanding loan if the buyer defaults.

According to the latest Bank of England data, the spread between a two-year fixed-rate mortgage for 75 per cent of the purchase price and a similar loan for 95 per cent of the purchase price is now 0.88 of a percentage point. That is about three times the differential in December. Historically, the two rates were, on average, not more than about a quarter of a percentage point apart.

Separately, Experian, the personal credit rating group, has identified five postal codes in the UK where the average home loan is 90 per cent or more of the median home price and which are most vulnerable to negative equity in a downturn.

Sighthill in Glasgow is most at risk, with average loans totalling nearly 95 per cent of the average house price. One London postal code is at risk: SE18 in Woolwich, where the loan-to-value ratio is more than 91 per cent. Meanwhile, Alliance & Leicester is considering repricing its mortgage deals for the second time in a week following moves by rivals.

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