Banks not lending to each other

by L. Berney

From what I understand from the media, the cause of the worldwide economic slow-down, the recession, is because the banks have severely reduced the mortgages they are issuing, and the loans they are prepared to make to individuals, commercial firms and institutions. Moreover, any such mortgages and loans are at much increased interest rates.

The reason for the banks' sudden reluctance to lend is said to be because. “the banks are no longer willing to lend to each other”.

I always understood the banks’ operation to be this. Individuals, firms and institutions deposited money with their banks. The banks then lent most of that money to other individuals, firms and institutions. Banks “lending to each other” played little or no part of the process.

(I am aware that a small minority of banks, e.g. Northern Rock, augmented their deposit income by borrowing from other banks, but I thought that this was very much the exception, not the rule.)

Can anyone explain to me where my understanding is wrong? Is it true that the reason banks are not making loans is because they are not lending to each other -- and if so, why?