Eg. Usually I loan out $1 billion. But now, my risk appetite is smaller because of my desire for a smaller leveraged balance sheet, hence i will loan out only $100 million.
So even if I trust that you are able to pay back the loan, I will no longer lend to you because I have no desire to lend so much anymore. The overall credit supply decreases.
Maybe my initial post was not clear, I believe the main reason for the tight market is this: Constriction of desired leverage -> Decreased credit supply
Eg. Assuming the precrisis loan-to-cash mean leverage is 500%, USD 100 billion of cash can yield USD 500 billion of loan supply in the credit market. Now, the loan-to-cash mean leverage is about 200%, so the same USD 100 billion of cash will yield only USD 200 billion of loan supply. Thus, the Fed has to print a lot more cash to restore the precrisis credit supply. The announced capital injection is not enough. They have to inject a lot more. If they don't wish to print that much cash, the Fed can be the direct lender and assume the precrisis leverage themselves.
But a higher borrowing cost is not a problem unless it is so prohibitively high that it prevents lending, which, judging by the relatively steady loan amounts, it has not.
The necessary supply of funds is there, it's just that no one trusts anyone, so they are charging lots more for the risk.
For an analogous situation, consider this: The Fed decides to institute a lottery, where they pick a random bank every day. Whichever bank is picked gets shut down, and all their creditors and depositors get nothing. This is obviously very bad for whichever bank is picked, and bad for anyone who lent money to that bank. No one knows who is going to be next, so they charge everyone higher rates to account for the risk. There is still plenty of money to lend, and there is still a market for the loans, it's just that there is extra risk of a random insolvency event.
In the real world, the illiquid and non-transparent Asset Backed Securities are like the Fed lottery, in that, by marking them to market, all it takes is one lowball transaction by third parties to crater a bank's balance sheet, forcing it into insolvency. Since no one knows who still is at risk, they are charging higher rates. It's not because they don't have the money to lend, it's because it is better to have the money sit idle than to lose it. (And in the case of some banks, it is better to have cash on hand in case their own asset-backed securities become worthless. Even lending it to a perfect borrower is riskier in that case, because even if the borrower can repay, it's no good to the bank if they need the cash in a pinch.)
it is better to have cash on hand in case their own asset-backed securities become worthless. Even lending it to a __perfect borrower__ is riskier in that case, because even if the borrower can repay, it's no good to the bank if they need the cash in a pinch.
In other words, the issue here is that the banks are reducing their leverage and not because they don't trust each other, which is my main point. If the Fed inject so much money into the banks that they can afford a few loan defaults here and there, the credit market will start to go back to precrisis levels. An interbank lending guarantee without the capital injection won't help much.
Conversely, if the Fed sets a price for troubled assets, each bank will know where they stand, and they won't have to hoard cash any more. Those banks that made bad decisions will fail, as they should, and those that didn't will see confidence in them restored.
A direct capital injection offers blanket protection to all banks, good and bad, and does nothing to discourage this from happening in the future.
Eg. Usually I loan out $1 billion. But now, my risk appetite is smaller because of my desire for a smaller leveraged balance sheet, hence i will loan out only $100 million.
So even if I trust that you are able to pay back the loan, I will no longer lend to you because I have no desire to lend so much anymore. The overall credit supply decreases.
Maybe my initial post was not clear, I believe the main reason for the tight market is this: Constriction of desired leverage -> Decreased credit supply
Eg. Assuming the precrisis loan-to-cash mean leverage is 500%, USD 100 billion of cash can yield USD 500 billion of loan supply in the credit market. Now, the loan-to-cash mean leverage is about 200%, so the same USD 100 billion of cash will yield only USD 200 billion of loan supply. Thus, the Fed has to print a lot more cash to restore the precrisis credit supply. The announced capital injection is not enough. They have to inject a lot more. If they don't wish to print that much cash, the Fed can be the direct lender and assume the precrisis leverage themselves.
Here's a good article that explains it all: http://www.bbc.co.uk/blogs/thereporters/robertpeston/2008/10...