A cash freeze has gripped world financial markets as fearful banks hoard billions and billions of dollars and prefer to leave it on deposit with central banks and earn less than they could get from lending it to normal business and personal customers. Not even Australia is exempt: our well capitalised banks are following suit

Banks around the world are refusing to deal with each other, or anyone else, so they are leaving tens of billions of dollars on deposit with central banks. The drought has worsened significantly since the collapse of Lehman Brothers 10 days ago and still rising losses taken by bond holders and other investors.

Bank nervousness seems to have picked up from earlier this week as the progress of the US bailout proposal slows in the Congress. If that proposal was to fail, markets would dry up. If there is a reason why the global economies slump into recession or worse, it will be this cash drought. The money’s there, tucked away in cash management accounts and at central banks, but no one is willing to lend. There is no shortage of borrowers. Central banks in the UK and Australia have moved within the past 24 hours to ease the drought by moving to mop up the cash.

The drought has seen short term interest rates around the world rise sharply as banks choose to leave their money with the central bank, or invest in short term US Government treasury notes as the ultimate short-term safe haven.

Short term US treasury note rates have again fallen under 1% while short term US dollar (and some other currency) LIBOR rates in London has jumped sharply to levels seen in the dark days of early January. The three-month US Treasury bill traded at 0.49% in New York overnight, down from 0.79% at the close Tuesday and 0.88% on Monday.

The demand for short term, security can be seen from the results of a huge US Treasury auction of $US34 billion in two-year bonds: demand was about normal for the moment at 2.2 times the amount offered. Market yields for the notes traded down to 2.02%,

In Australia yields on 90 day bank kills, the key short term funding source in the country, have risen to where they are higher currently than 180 day bills. It is normally the other way around. Spikes like we are seeing are signs of a cash shortage.

At the same time, the weight of cash being kept at the RBA by nervy banks is pressing down on the 7% cash rate and causing problems for the central bank.

Since the squeeze started early last week after Lehman failed yields on bank bills have not only risen by around 0.20% or more, the yield on the 30 day bill has exceeded or equalled that on 90 day securities on some days, so intense is the cash drought in the markets. The 90 day bill yields on Tuesday and yesterday were the highest since early last month and a sign that there’s less and less cash available to be lent.

There’s an increasing chance the Reserve Bank will not only cut rates 0.25% next month, but it might have to make it a 0.50% cut to try and free up lending.

As a result The Reserve Bank of Australia has been forced to introduce a new way of mopping up the surplus cash, while the Bank of England is taking back billions of pounds of extra liquidity it has been pumping into the system because banks are hoarding it.

Similar situations are being reported in the US where New York sources claim that a big pan-Asian bank, has $US2 billion on deposit with the Federal Reserve, paying no interest, so scared is its management at the moment.

This is also why the Fed has been doing US dollar swaps with central banks around the world: the $US10 billion swap with the RBA (and another $US20 billion with Scandinavian Central Banks) is aimed at injecting more US dollars into various regions. So far swaps of over $US270 billion have been announced since late last week, with the lion’s share going to the European Central Bank which seems to have few problems in getting banks to take up and use the funds.

Banks in the US, Britain, Australia, Scandinavia, Canada and Japan are reported to be sitting on cash: especially US dollars.

This hoarding has contributed to a sharp rise in short term US borrowing rates in London and a sharp drop in the yield on US Treasury Notes in the US: as well Citigroup has estimated overnight that hedge funds have plonked $US100 billion or more in ordinary every day cash management accounts, especially in the US because they can’t fund a home for their funds.

The Reserve Bank announced a new liquidity management tool yesterday in tandem with the swap announcement with the Fed.

Since last Thursday when the crisis worsened, banks and other institutions who deal with the RBA have been leaving over $A6 billion in their exchange settlement accounts with the RBA each night. They receive 0.25% less than the cash rate to do that, but have become more and more worried about the risk of someone, somewhere defaulting overnight.

That cash has been pushing down on the cash rate and the new term deposits are a way of offering banks another outlet for their cash that takes the money out of the system and puts it onto the RBA balance sheet. They can be called if needed, but are not in the system directly each day.

That will make the RBA’s daily market operations easier to manage.

The bank explained the move in central banker-ese: “To further enhance the flexibility of its domestic liquidity management operations, the Reserve Bank will offer a short-term deposit facility (to be known as RBA Term Deposits).”

The RBA will conduct auctions at which eligible institutions will be able to bid for deposits: the first will happen next Monday. The Reserve Bank will pay a rate as low as possible (even under the cash rate) on the deposits: it will accept the lowest offered margin first and the bids with the highest rate last.

It will be run in addition to the current system of injecting funds each morning via repurchase deals involving government bonds and other securities as well as asset backed commercial paper and residential backed mortgages.

Analysts said the bank is trying to attract some of the excess overnight funds that banks are holding as they refrain from lending to each other in the wake of the Lehman collapse.

In London the Bank of England is trying to get UK banks to take back the 6 billion pounds (more than $A13 billion) of overnight funds they have left with the central bank rather than lend it to each other for more than a few days even though it means they earn less interest on their money.

The Bank of England said overnight that banks had put the £5.9 billion in its safe but low-interest deposit standing facility since Tuesday night by increasingly worried banks looking for complete safety.

The central bank has reacted by taking back most of the additional 25 billion pounds ($A55 billion plus) of liquidity it injected into UK money markets last week to relieve liquidity strains.

Yesterday the bank also soaked up another £10 billion pounds ($A22 billion) of surplus overnight cash from the banking system.

Market participants say the loss of funding relates not just to banks refusing to lend to each other at anything other than the shortest durations, but money market funds and asset managers making similar decisions.

It’s just not banks wanting not to lend, money market funds and other cash and sources of funds are also not dealing with one another.