Abstract
The wholesale interbank market (where banks trade with each other) reduces the risk for banks making forward commitments to lend at retail–to households and firms, including exporters and importers. The collapse of the U.S. housing bubble in 2007–08 impaired bank balance sheets so that banks became reluctant to lend to each other from counterparty risk. Retail bank credit fell sharply, thus worsening the crisis. By 2009, the U.S. government had responded by recapitalizing large commercial banks and by flooding the system with liquidity so as to drive short-term interest rates close to zero. Although counterparty risk is now in abeyance, forcing short-term interest rates at zero is a serious mistake. Wholesale interbank lending is still inhibited so that retail bank credit is unlikely to recover–and continues to fall in 2009.
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