Central banks split over credit squeeze/Fed looks beyond discount rate to control liquidity/ECB loans banks further €75bn

Central banks split over credit squeeze
By Chris Giles and Gillian Tett in London
Copyright The Financial Times Limited 2007
Published: September 12 2007 18:34 | Last updated: September 12 2007 18:34


A clear divide between the world’s leading central banks over how best to respond to the credit squeeze emerged on Wednesday after Mervyn King, Bank of England governor, warned that efforts by his counterparts to shore up the financial system could sow “the seeds of a future financial crisis”.

In a trenchant defence of the Bank’s refusal to address the abnormally high interest rates for longer-term lending between banks, Mr King questioned the effectiveness of the kind of measures taken by the European Central Bank and said their approach could encourage “excessive risk-taking”.

The ECB pumped an extra €75bn (£51bn) into the financial system in an effort to reduce the interest rate gap between overnight funding and lending over longer maturities.

But in a written submission to the Commons Treasury select committee, Mr King warned of the hazards of providing central bank insurance to those institutions that have engaged in reckless lending.

“The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises,” he added. Central banks should not “sensibly entertain” such cash injections just to maintain the status quo, he added.

His remarks came as Alistair Darling, the chancellor, attacked banks for lending too freely and allowing consumer debt to soar. In an interview in Thursday’s Daily Telegraph, he calls for a return to “good old-fashioned banking”.

In the money markets, the cost of borrowing for three months in the London interbank market fell slightly on Wednesday in all areas.

The dollar also fell to a lifetime low against the euro of $1.3914 on expectations that the Federal Reserve will cut interest rates.

The disagreement among central bankers centred on how far they should go to try to normalise conditions in money markets.

The ECB said last Thursday it would pump three-month money into the system to “support a normalisation of the functioning of the euro money market”. Both Mr King and Mr Dodge said commercial banks were strong enough to absorb the assets of troubled investment vehicles.

Separately, policymakers are set to step up calls for greater transparency in the structured finance world when EU finance ministers meet in Portugal on Friday. Discussions are also continuing over other responses to the crisis, such as a review of bank capital standards or efforts to pool distressed assets.

Additional reporting by Krishna Guha in Washington


Fed looks beyond discount rate to control liquidity
By Krishna Guha in Washington
Copyright The Financial Times Limited 2007
Published: September 12 2007 20:30 | Last updated: September 12 2007 20:30


As Federal Reserve policymakers look ahead to next week’s decision on interest rates, staff at the central bank are continuing to work on other potential steps that could be taken to address liquidity problems in financial markets.

The possible steps range from the relatively orthodox – a disproportionately large cut in the discount rate at which the Fed lends directly to banks – to more unorthodox measures.

At issue is whether it would be worth the Fed dusting down some rarely used tools – or improvising new ones – to help it reach beyond the banking system and channel liquidity to where it is needed most.

Ben Bernanke, the Fed chairman, flagged up the possibility in a speech at Jackson Hole at the end of last month when he said the Fed “stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets”.

The obvious step would be to cut the discount rate by more than the main federal funds rate. For instance, if the Fed cut the funds rate by 25 basis points, it could cut the discount rate by 50 or even 75 basis points, reducing (or in the latter case eliminating) the effective penalty on direct borrowing.

This would both encourage greater use of the discount window facility and make it a more effective back-stop for the money markets.

The Fed has already cut the discount rate by 50 basis points to reduce the direct borrowing penalty. The aim is to make banks feel comfortable lending to non-bank financial institutions against good collateral, by letting them know they will in turn be able to raise funds from the Fed against that collateral at reasonable rates.

The discount rate is set by the Washington-based board of governors, not the full federal open market committee, so there is no reason why the Fed would have to announce any change alongside the rate decision next Tuesday. But a number of analysts expect that it will.

Some also believe the Fed might consider extending the term of its open market operations, as the European Central Bank has done.

Meanwhile, work is believed to be continuing on more unconventional policy steps that could be deployed if required in the future.

Fed officials see ensuring the effective functioning of markets as a critically important mission but one that is distinct, at least in the first instance, from their other main mission of managing the macroeconomy.

So they are keen to revisit the liquidity support tools at their disposal – tools that in many cases are rusty from lack of use over the years.

There are a number of ways in which the Fed could try to reach beyond the banks to the stressed non-bank financial sector and the distressed markets for asset-backed commercial paper and non-agency mortgage-backed securities.

Indeed, some of these approaches have been tried in the past, as Richard Berner, chief economist at Morgan Stanley, points out in a recent research note.

One option would be to set up a facility to lend directly to non-banks against their collateral, loosely modelled on the joint lending programme put in place in 1989 at the height of the savings and loans crisis.

Another option would be to establish currency swaps with European central banks to deal with pressure on the offshore dollar money markets, similar to those put in place after the terrorist attacks of September 11 2001.

The Fed could also mimic measures used in 1999 to guard against the fear of a Y2K liquidity drought at the turn of the millennium.

These included the creation of a temporary special liquidity facility that would accept commercial paper at a discount and the sale of call options giving banks the right to tap Fed loans in the future if required at guaranteed rates.

None of these steps appears imminent but their use should not be ruled out, particularly if markets take a fresh turn for the worse.

Mr Berner said the Fed’s main concern would be to ensure it did not end up taking any credit risk and that any unorthodox arrangements were truly temporary.

“It is like a military operation – you need an exit strategy,” he said.



ECB loans banks further €75bn
By Gerrit Wiesmann in Frankfurt
Copyright The Financial Times Limited 2007
Published: September 12 2007 12:12 | Last updated: September 12 2007 12:12


The European Central Bank on Wednesday loaned commercial banks €75bn ($104bn) for three months, a sign that institutions in the money market remain wary of lending to each other for periods of more than a week.

The Frankfurt-based central bank said 140 banks had applied for €139bn in central bank deposits, agreeing to pay an average interest rate of 4.52 per cent as compared with current interbank prices of 4.75 per cent.

The size of the refinancing operation shows how worried commercial banks remain that the crisis in the US mortgage market could yet render fellow institutions in the money market unable to repay loans.

It chimes with remarks by US Treasury secretary Henry Paulson that, even as short-term lending normalises, the crisis of confidence in the credit markets could last longer than any recent financial crises.

The ECB in August led global central banks in making short-term cash available to commercial banks as worries about mortgage-induced defaults all but halted vital interbank lending on the money markets.

In a sign that short-term lending may be normalising, the ECB drained €60bn in so-called overnight cash from the market. But commercial banks remain reluctant to lend to each other for long periods.

As a result, demand for longer-term central bank loans is up. The €139bn in three-month ECB loans the banks bid for compares with €126bn in bids when the ECB carried out a first special three-month tender in August.

The size of Wednesday’s allocation of cash – €75bn against €40bn last month – also showed that the ECB recognises that longer-term interbank lending has become more fraught, and that it remains willing to act.

Jean-Claude Trichet, ECB president, has repeatedly pledged to make extra cash available to the credit markets if their smooth functioning is threatened by commercial banks hoarding money for fear of defaults.