(Updates with Fed rate decision, fed funds trading in late New York trade)
NEW YORK/LONDON, Sept 16 (Reuters) - The banking crisis deepened on Tuesday as the cost of borrowing overnight surged above 10 percent, signaling mistrust between banks has escalated amid deep concerns about the U.S. financial system.
With the fate of American International Group Inc AIG.N unclear and continuing fallout from Lehman Brothers' collapse, the interest rate banks demand for lending dollars overnight to other institutions ballooned to more than five times the U.S. Federal Reserve's 2 percent target rate.
London interbank offered rates (Libor) for overnight dollars as fixed by the British Bankers Association -- to which trillions of dollars of derivative, financial and corporate contracts are referenced against -- soared to 6.43750 percent, the highest since January 2001.
Shortly after the U.S. Federal Reserve added a combined total of $70 billion temporary reserves to the banking system early on Tuesday, matching Monday’s total and the biggest daily total injection since September 2001, the U.S. interbank lending market showed high stress.
Federal funds traded in the U.S. interbank market rose briefly to 4 percent, doubling the 2 percent target rate the Federal Reserve sets, before slipping to 1 percent in late New York trade.
One-month borrowing rates for U.S.-based banks as reflected by ICAP's one-month New York Funding Rate USNYFR1M= spiked to 2.8491 percent from the previous session's 2.5200 percent.
“Overnight rates remain elevated relative to the fed funds (target) rate,” said Jay Mueller, senior portfolio manager with Wells Capital Management, in Milwaukee, Wisconsin.
“Obviously, the liquidity injection is aimed at getting these back down again,” he said, adding, “We don’t know how much money that will take.”
The money market paralysis on Tuesday wasn’t confined to dollars: overnight sterling Libor was fixed at 6.79375 percent, its highest since April 2001 and well above the Bank of England’s 5 percent base rate.
The premium paid for three-month dollar Libor over anticipated central bank policy rates according to Overnight Index Swaps widened by more than 10 basis points to the widest since the crisis hit financial markets in August last year.
“The banking crisis is not over and we have potentially a difficult few months to get through right to the end of this year,” said Padhraic Garvey, head of investment grade strategy at ING.
The dramatic rise in dollar Libor rates and spreads amid deepening financial market turmoil reflects the scarcity of dollars in European trading hours, funds that European institutions desperately need to cover short-term dollar liabilities and exposures.
That need has been made even more pressing since the collapse of Lehman and the increasingly precarious situation of many other financial firms, such as U.S. insurer American International Group.
Reuters charts showed overnight dollar deposit rates indicated as high as 11.50 percent on Tuesday but market participants said banks’ reluctance to lend meant deals were only being done at much higher rates before easing as New York opened.
Sources in London said the drying up of dollar funds is as serious as anything seen during the entire global financial crisis.
“This is much worse than August last year,” said one source.
Another said: “European banks can’t get dollars. Banks are hoarding (cash) in case of payment issues,” related to the collapse of Lehman Brothers.
“We need the ECB and SNB to start providing more dollars,” he said.
The European Central Bank was among several central banks that pumped short-term funds into their local money markets on Monday to help ensure the functioning of these interbank markets.
On Tuesday, the Bank of Japan and Bank of England were among the major central banks of industrialized nations that injected funds into their markets, with the BoE providing a hefty 20 billion pounds.
But it’s dollars that banks are short of.
“I don’t want to provide liquidity for other banks which don’t have a client customer status,” said one rates trader.
“If we look at the electronic platforms there is hardly any liquidity there. What we’re doing here, we’re providing liquidity on a 10-cent spread between bid and ask, normally the spread is about 3 or 4 cents.”
In another sign of how frozen interbank markets are, bankers said Norway’s foreign exchange swaps market was not functioning. The country’s central bank said it will carry out an auction next week of one-week FX swaps.
“Intensifying stress in money markets overnight (partly due to dollar funding strains in Europe) and a sharp slide in U.S. and global equity markets...raise the question of what central banks might do in a coordinated fashion to relieve strains and bolster confidence,” wrote Bruce Kasman, chief economist with JPMorgan Chase in New York in a research note on Tuesday.
“We look for some coordinated action on liquidity provision by central banks in the coming day or so. But we do not expect coordinated rate moves,” Kasman wrote.
The Federal Reserve held its benchmark interest rate, the fed funds target rate, unchanged at 2 percent at its regular policy-setting meeting on Tuesday, surprising some market participants. Short term interest rate futures had implied that a 25 basis point Fed rate cut was the most likely outcome. (Additional reporting by Ian Chua, Emelia Sithole; Chris Reese and Ros Krasny; Editing by Leslie Adler)
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