Major Central Banks Step in Over Credit Crunch

The Federal Reserve, the European Central Bank, the Bank of England, the Bank of Canada and the Swiss National Bank announced on Wednesday that they would coordinate their efforts to fight the current credit crunch. These efforts include a new credit auction from the Fed, some currency swaps, and loosening collateral rules for commercial banks. Even as they made their announcement, the SNB's Thomas Jordan said, “Central banks can not compensate for this lack of confidence simply by injecting additional liquidity.”

The Fed’s new credit auction will come in four stages, the first two of $20 billion each, the other two at levels yet to be decided. This facility will accept collateral that is normally not applicable to Fed Funds rate borrowing, such as housing-related securities. There is a sense that the Fed’s discount rate (a half percent higher than the Fed Funds at present) needs augmentation as there is a stigma about borrowing against that rather than taking the Fed Funds loan. However, this may not all be new money as the Fed could well reduce the amount it makes available in open market operations.

The ECB and the Swiss National Bank are entering into swap arrangements with the Fed to auction $24 billion in dollar funds to banks in Europe. This will allow those central banks to loan dollars to financial institutions in Europe with bad dollar-denominated debt on their books. Otherwise, those institutions would have to buy dollars in the currency markets, which would drive up euro-zone money market rates – not exactly what one needs in a credit crunch.

The Banks of England and Canada have taken a rather pragmatic step, simply letting riskier collateral be used in borrowing by financial institutions. This means that securities like unsellable collateralized debt obligations (CDOs) would be used to secure loans at cheaper rates. This would reduce the cost of debt servicing. At the same time, this can easily be undone if the central banks choose.

Still, there remains Mr. Jordan’s unpleasant truth. It is one thing for the central banks to provide liquidity in a time of instability; indeed, they have probably avoided a year-end accounting driven disaster. At the same time, they cannot make financial institutions loan money. Psychology right now is more important in the markets than economics.

© Copyright 2007 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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