The European Central Bank shovelled in tens of billions into the continental banking system last week.

What happened next?

The banks parked the money right back with the ECB — at 3.75% rate of interest — instead of on-lending more lucratively to local companies.

Financial crisis may push up interest rates: RBI

Such pathological fear of lending has frozen up cash-credit/working capital lines — or the money needed to run everyday business — of companies in Europe, putting at risk economic growth in many countries.

Can something similar happen in India?

Liquidity has been tight for companies over the last many weeks, as indicated by the 3- and 6-month certificate of deposit (CD) rates, which are hovering around 14% plus. The rates have risen 150 basis points in the last week alone.

Banks have little exposure to distressed assets: RBI

Remember, this is for top quality or the so-called 'AAA' rated corporates.

The spreads or the difference between the interest rate on 3-month treasury bills (a government-guaranteed paper) and CDs (issued by companies) was a phenomenal 645 basis points on Saturday, according to Bloomberg data, while those between ten-year bonds are at an all-time high of over 350 basis points, underscoring the level of aversion towards non-sovereign issues.

More India business stories | Get the latest Sensex update

The spread between three-month Mibor and Overnight Indexed Swaps was totally out of whack at 384 basis points on Saturday (it was 478 bps on Friday).

That's nearly a trebling of risk premium; the wider this difference, the lesser the inclination to lend.

Which tells the story starkly: there is little faith between banks; the lending bank is thinking the borrower-bank (or its clients) could default and is therefore charging a higher interest rate, a higher risk premium.

Quick question: What happens if sentiment turns more negative, just as in Europe? If counterparty risk becomes a Frankenstein's monster?

Already, realtors, non-banks, airlines and oil marketing companies are pariahs in the local credit market. When AAA-rated companies are finding the going very tough, imagine the pressure on lesser life-forms.

Borrowing abroad is not an option because that shop is already shut. Domestic liquidity remains the critical pipeline and it cannot be left clogged.

Remember, what short-term interest rates of 14%+ means is that to survive, the borrower-company's return on capital should be around 25-30%.

This pre-condition accentuates the stress on corporates, more so in an economy that is slowing down right now.

Accumulation of such pressure can lead to defaults on basic interest payments or on the principal itself.

If corporates are forced to fight for basic day-to-day liquidity, it also exaggerates economic contraction.

Demand destruction plus liquidity crunch - when did we last have that?

In the mid-nineties, when rates peaked and threw up massive problems with the textiles and steel sectors, and with financial institutions.

More India business stories | Get the latest Sensex update

Yes, the Reserve Bank of India (RBI) has been prudent, so has many liquidity-infusing weapons at hand, such as cutting the statutory liquidity ratio some more, the cash reserve ratio once again, and, of course, the Rs 170,000 crore of market stabilisation bonds.

But all of that will be of no help if local banks do not feel like lending.

It's time for some confidence-building measures by RBI, time to plumb before fear clogs credit flow.

Under license from www.3dsyndication.com