If banks can't trust each other, who can they trust?

This feature is part of our FREE daily Money Morning email. If you'd like to sign up, please click here: Sign up for Money Morning

Yesterday was a catastrophic day for the markets.

That's not an exaggeration. The European Central Bank was forced to intervene in the credit markets, pumping the biggest chunk of money into the system since the terrorist attacks of September 11th. The move came after a warning by BNP Paribas, that it was banning withdrawals from three of its funds, sent the cost of money that banks lend to each other soaring.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

As stock markets across the globe plunged, the powers-that-be even felt the need to wheel out the US President to calm everyone down. Given that US Treasury Secretary Hank Paulson has been calling the bottom of the market every few days for months now, they probably felt his credibility was getting a little stretched.

George W Bush rose to the occasion. "I am told that there is enough liquidity to enable those markets to correct. The fundamentals of our economy are strong."

Yeah, and the war in Iraqll be over by Christmas, eh George?

So what exactly ignited all the upheaval?

BNP Paribas, France's largest bank, stopped withdrawals from three of its funds, which had around €2bn invested in the US subprime market. Following on from the near-bankruptcy of Germany lender IKB, it sent waves of fear through the banking sector.

Basically, banks are becoming reluctant to lend each other money because they don't know what kind of bad investments their rivals and colleagues have made. As Chris Low of FTN Financial tells The Telegraph: "There is an element of distrust that is creeping into the interbank markets, and if banks don't trust each other, that's a big worry."

That distrust saw the European interbank rate spike to 4.62% (from around 4%) at one point. That was when the European Central Bank stepped in with promises of "unlimited lending" to calm everyone down. It pumped £64bn into the system, while the US Federal Reserve stepped up with £12bn.

The carnage is continuing this morning. The Nikkei 225 dived more than 400 points, and the Japanese and Australian central banks are busily pumping cash into the breach. The Bank of Japan added $8.5bn to the financial system, while the Reserve Bank of Australia added $4.2bn.

As Damian Reece rather succinctly puts it in this morning's Telegraph: "The fact that Libor [interbank lending] rates jumped reveals that banks no longer want to lend money, a fairly major problem in any economy. They don't want to lend to each other because they've lost confidence."

The reason they've lost confidence is because they've got no idea who's holding which toxic assets, and how much they are worth. And because no one's willing to attempt to sell in a market with no buyers, that confusion isn't going to clear up any time soon. They're also uncomfortably aware that they may soon need all the spare liquid cash they can lay their hands on, because they're sitting on a whole lot of lending commitments that they may not be able to sell on the debt markets.

Now, if the banks don't even want to lend to each other, how's that going to affect how they feel about lending to companies? Or to you and me?

Throughout the Western world, but particularly in the UK and the US, economic growth, and each person's standard of living, have been propped up, or relied exclusively on the availability of cheap money.

That era is ending right now. Suddenly, it's going to be better to be a saver than a spender; to have piles of cash in secure investments, rather than piles of debt leveraged against high-risk punts. You can read more about what the end of cheap money means here: Is the tidal wave of cheap money about to break? (/file/32904/is-the-tidal-wave-of-cheap-money-about-to-break.html)

If you're not already a subscriber, you can sign up for a three-week free trial by clicking here: Sign up for a three-week free trial of MoneyWeek. (/file/194/subscribe-from-not-logged-in.html)

And just before we go, here's news of a British Banking Association conference that might be of great interest to some readers, particularly in light of recent events. It's the BBA's Converging Alternative Investments Seminar, and it takes place on 10th September 2007, at KPMG, 8 Salisbury Square, London EC4Y. The BBA will be presenting a very senior line-up of speakers from the alternative investment industry. Leaders from hedge funds, private equity, real estate and pension funds, including Jon Moulton of Alchemy Partners, will be talking about how those in the alternative investment industry are increasingly competing for the same assets. They'll be looking at why this is happening and what potential risks are arising.

Turning to the wider markets

Enjoying this article? Why not sign up to receive Money Morning FREE every weekday? Just click here:FREE daily Money Morning email

In London, concerns over the credit market resurfaced yesterday, sending the FTSE 100 tumbling 122 points to close at 6,271. Copper miners Kazakhmys and Antofagasta were amongst the hardest hit, and hedge fund Man Group and private equity outfit 3i both fell heavily. For a full market report, see: London market close

It was also a bad day for stocks on the Continent. In Paris, the CAC-40 slumped 118 points to 5,624, whilst the Frankfurt DAX-30 was 125 points weaker, at 7,453.

Across the Atlantic, the Dow Jones recorded its second-worst close of the year, plummeting 387 points to end the day at 13,270. Financials including Citigroup and JP Morgan Chase were amongst the hardest hit. Financial stocks weighed especially heavily on the S&P 500 which fell 44 points to 1,453. And the tech-heavy Nasdaq was down 56 points to 2,556.

Asian markets tracked Wall Street lower overnight. The Japanese Nikkei fell 406 points to 16,764. The Japanese central bank followed the ECB's lead and injected 1 trillion yen into the market in order to boost liquidity. And in Hong Kong, the Hang Seng was down by as much as 646 to 21,792.

Crude oil had fallen to $71.42 and Brent spot was at $69.76.

Spot gold fell by nearly 2% yesterday to as low as $659.50 as trouble in the equity markets spread but had risen to $663.10 this morning. And silver was at $12.65.

In the currency markets, sterling was down against both the dollar and the yen this morning as investors sold off high-yielding currencies and piled into the yen. The pound was at 2.0212 against the dollar and 238.37 against the yen. And the dollar was at 117.96 against the yen and 0.7303 against the euro.

And stocks continued to slide across Europe this morning. The FTSE 100 opened nearly 2% lower and the CAC-40 and DAX-30 were down by as much as 1.88 and 1.9.%. Financials continued to be hardest hit: Man Group had fallen by as much as 8% and Barclays and Royal Bank of Scotland were also down. You can keep an eye on what's happening in the markets throughout the day here: MoneyWeek news

And our two recommended articles for today...

How to milk the rise in dairy prices - It's going to make your Dairy Milk and your Domino's pizza more expensive, but the rising cost of milk is also creating great investment opportunities. Click here to find out which stocks will benefit most: How to milk the rise in dairy prices

Is the global property market about to crash?- As regular readers will know, we at MoneyWeek are distinctly bearish on UK property, but what of the rest of the world? In a recent issue, property investment expert Fred Harrison explained why he believes that property prices are in the final growth year of an 18-year cycle. For more on why the fundamentals suggest a global house price slump next year, read: Is the global property market about to crash?