The WSJ Market Beat Blog has a post called the LIBOR disconnect:

The question is, where will the money come from? The short-term funding needs of banks have largely been satisfied in the overnight and short-term lending markets, where banks borrow from each other, using unsecured loans, paying the London interbank offered rate, or LIBOR, which generally is set a few hundredths of a percentage point above the U.S. Federal Reserve’s federal-funds target.

Right now, the best option for Citigroup and others is the Federal Reserve. Thanks to the various lending facilities the Fed has set up, banks have been working around their inability to borrow from each other (a self-serving cycle, in a way) by going to the Fed.

So why aren’t the banks lending to each other? The Fed funds rate is 1.5% and overnight LIBOR is around 1.9% and three month LIBOR is around 4.5%. Pretend you are a bank for a minute with a need for an overnight loan. Would you rather borrow from the Fed at 1.5% or another bank at 1.9%? Well, I would take the lower rate, how about you? Need a longer term loan? Well, you can go to the TAF, as long as you have collateral, and get 28 or 84 day loans. The last auction had a stop out rate of 1.39%. If the Fed is offering such good terms and there is no stigma associated with borrowing from the Fed, a banker would be breaching his fiduciary duty to shareholders if he paid a higher rate.

How is the Fed going to get out of this? The only way I can see to get this market functioning again is for some large bank to offer to lend a huge amount at the Fed funds rate. If JP Morgan were to enter the market and offer to lend at a low rate, it might restore some confidence and get other banks in the market. With the entire banking system being essentially guaranteed by the world’s governments, the risk to lenders is low.

Another reason banks may not be willing to lend in the interbank market is that the Fed now pays interest on reserves held at the Fed. Required reserves are paid interest at 10 basis points less than the Fed Funds rate. Excess reserves are paid at Fed funds less 75 basis points. It’s those excess reserves that need to make their way into the interbank market.