Innovation from the Fed and the ECB

Dec 19, 2007 - CENTRAL bankers are not known for their creativity. However, over the past week, two of the world's largest central banks have come up with some innovative ways to deal with the severe crunch that has engulfed global credit markets since August. But how effective this improvisation will prove remains to be seen.

On Dec 12, a day after it cut the Fed Funds rate by 25 basis points to 4.25 per cent, the US Federal Reserve announced, for the first time, a Term Auction Facility (TAF) to auction reserve funds for up to 35 days to American banks against a wide variety of collateral. It also set up swap agreements with the European Central Bank (ECB) and the Swiss National Bank to enable them to provide dollars to banks in Europe. Then, on Monday, the ECB took the unusual step of offering unlimited funds to banks at below-market rates.

Both these moves are aimed at enabling liquidity-strapped banks to obtain funding. In the US previously, such banks had to borrow from the Fed at penalty rates and against good collateral. Banks that did so faced being stigmatised, with the result that the facility was under-utilised. But now, the Fed will be auctioning funds against a broader range of collateral, with all banks eligible to participate. The ECB's action is likewise aimed at improving banks' access to funding and reducing borrowing costs.

In assessing to what extent these actions will ease the credit crunch, it's important to understand why liquidity has dried up in the interbank market in the first place. Essentially, this has happened because of uncertainties about counterparty risk; banks are suspicious about the quality of each other's assets. As a result, interbank rates have spiked up.

The question is whether generous provision of liquidity on special terms by the Fed and ECB can arrest the problem. We won't know for sure until we see the results of the Fed's auctions (the first of which will come later today). Particularly closely watched will be the spread of Libor (the rate at which large banks lend to each other) over policy rates. This differential has spiked significantly since August. If it narrows and this is sustained, the moves by the Fed and ECB could be claimed to have had some success.

There are, however, reasons to be sceptical. As some commentators have pointed out, the credit crunch may be more a problem of solvency than of liquidity. That is, the counterparty risk of which banks are so fearful is real: a number of banks (and non-bank financial institutions, such as investment banks and mortgage companies) have masses of dud loans on their books. Confidence in the credit markets will return only when the extent of these impaired assets is better known. In this view, actions to provide additional liquidity to banks are no more than palliatives - possibly helpful, but not a cure. However, we will get a better picture as the Fed's auctions proceed and their results come in. But the chances are that it will be a while before credit markets return to normal.