A mighty union of central banks

The lending crisis that threatens the world economy is a malfunction of what has become a quintessentially global banking system – the only wonder is why it took so long for central banks to present a global response.

Four months after rumbling problems with US sub-prime mortgages infected the global financial system and froze interbank lending, the US Federal Reserve, European Central Bank and several others finally acted in unison yesterday.

Months of piecemeal national and regional policy measures to ease pressure on the world's biggest banks, who have written off more than $60 billion of bad debts and illiquid assets, have had little success in restoring order to global money markets.

Whether it was multi-billion-dollar writedowns at US-based Citi, Swiss-based UBS or UK-based Barclay's, the problems were far from local – these sorts of mega financial firms operate across the globe.

They raise funding and make loans in multiple jurisdictions and depend on many central banks for financing.

International operations at Citi, for example, accounted for more than 50 per cent of revenues in the third quarter.

As a result, a crisis of confidence in cross-border institutions of this scale means a crisis of confidence in banking and interbank lending everywhere and higher borrowing costs for everyone.

What's more, if any one of these global institutions were to fail, it is unlikely that any one national authority or set of authorities could cope with the fallout on its own.

Hence, yesterday's concerted announcement of a temporary short-term lending facilities by five of the world's most influential central banks – the Fed, the ECB, Bank of England, Bank of Canada and Swiss National Bank – was overdue.

"This is a global problem, with global firms, and it needs global solutions – and at last somebody seems to have woken up to that," said Paul Mortimer-Lee, global head of market economics at BNP Paribas.

"The central banks acting together and saying 'enough' has got to be positive," he added. "It will buy time and that may be crucial right now. And in any financial crisis, psychology has a huge role to play."

The welcome from financial markets at large was one of relief, not least after a small interest rate cut from the once all-powerful Fed was met with losses of more than 2 per cent on Wall Street stocks.

"I think it is a very creative and positive development," said Jim O'Neill, chief global economist at Goldman Sachs, referring the coordinated central bank moves.

Arcane cross-border web

The very nature of the US sub-prime mortgage crisis has been one of arcane cross-border links between banks and lenders who originated loans, repackaged and securitised them, and then sold them on to a vast array of investment funds and financial vehicles around the globe.

Many off-balance-sheet vehicles then used these assets to raise funding in a variety of different ways and in many centres. That the banks had not completely severed ties with them meant severe balance sheet pressures when funding dried up.

Concerns about the stability of interbank counterparties, the need to retain cash for backstop financing for many of these special funds and heavy writedowns of existing assets all mean the scramble for cash funds far outstripped supply.

Interbank interest rates – a bellwether for much of the borrowing rates across the global economy –soared and have stubbornly refused to ease as writedown jitters and funding concerns mounted into year-end.

In the scramble for cash, a hunt for the most favourable central bank funding terms was intense because the world's main central banks acted in a variety of ways to the problem.

British banks, for example, were widely reported as tapping ECB money auctions given the stricter terms at the Bank of England and the stigma attached to penalty borrowing there after Northern Rock's plea for help was met with a run on that bank.

But the likes of Germany's Deutsche Bank and Britain's Barclays, for example, also had extensive funding facilities at the Fed as a result of major US operations.

Yesterday's Fed actions included the setting up of a temporary term auction facility that banks can use to secure loans with a wide variety of collateral at its discount window.

But foreign exchange swap lines were also set up with the European and Swiss banks. These will provide dollars in amounts of up to $20 billion and $4 billion, respectively, for use in the euro zone and Switzerland.

"The problem was that banks needed funds in foreign currencies and that had become increasingly difficult because interbank markets were blocked," said Kornelius Purps, fixed income strategist at UniCredit in Munich.

"Now we finally have FX swaps, which makes it possible for European commercial banks to get hold of dollars on a short-term basis."

In the end, the ability and willingness of the authorities to act in concert rather than the effectiveness of the relatively modest amounts of money may well be most important.

The only problem, they say, is that it's unlikely they could coordinate monetary policy in the same way given the persistence of inflation.

"They are facing a global common problem, which is the credit crunch. It is a broad tightening of standards across the board," said Andrew Clare, director of investment advisers Fathom Financial Consulting. "The problem is, they are (also) facing more persistent inflation problems."