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Last Updated: Thursday, 13 December 2007, 12:10 GMT
Q&A: Why central banks are teaming up

Mervyn King
The Bank of England hopes this will ease credit concerns

Five of the world's central banks are to team up to offer cash loans, to be made available in auctions, to help banks deal with the credit crisis.

In this analysis, we take a closer look at the banks' actions and what the operation means for the global economy.

What are the central banks doing?

The Federal Reserve, the European Central Bank, the Bank of England, the Swiss National Bank and the Bank of Canada are to make up to $110bn (54bn) available to world money markets.

The money will be made available by auctions.

Central banks will accept a far wider range of collateral than they have done previously, making it easier for banks to borrow this money and reducing the stigma attached to asking central banks - the lender of last resort for commercial banks - for loans.

The European central banks are taking the unusual step of auctioning dollars, which they will access through $20bn of swap agreements with the Federal Reserve.

Their decision to do this reflects the difficulty that eurozone and Swiss banks currently have in gaining access to dollars.

The Bank of England will accept a wider range of securities as collateral than it usually does and has also dropped its penalty rate.

Why are they doing this?

The deal was hammered out at a meeting of the G20 in Cape Town, South Africa, last month.

Termed unprecedented by most analysts, it comes in the wake of a global credit crunch and a housing crisis in the US.

The crisis has its roots in the US mortgage market and the deals that lenders have offered to borrowers with poor credit histories.

Growing defaults by these borrowers have hit US mortgage lenders, but have also had a much wider global impact.

Much of this debt had been repackaged and sold around the world. As a result, a steady stream of banks have announced losses due to exposure to the US sub-prime market.

This has made banks wary of lending cash to each other, as they do not know what sub-prime losses are lurking either on their balance sheet or in off-balance sheet vehicles.

Banks with high loan-to-deposit ratios, such as Britain's Northern Rock, have been hardest hit, as they rely heavily on interbank funding.

ECB headquarters
In a rare move, the ECB will offer dollars in its auctions

Banks have also been loath to solicit loans from their central banks - the lenders of last resort for commercial banks - partly because of the stigma attached to doing so.

In the past week, the Bank of England and the Federal Reserve have cut interest rates, from 5.75% to 5.5% and from 4.5% to 4.25% respectively.

But this did not lead to lower money market rates - the rates at which banks lend to each other and which influence the rates at which they lend money to consumers.

The central banks hope to inject not just cash, but also confidence into the system, easing money market rates.

The central banks' fear is that commercial banks' reluctance to lend money to each other could ultimately foster reluctance to lend money to potential High Street borrowers.

This could potentially stymie economic confidence and ultimately growth - leaving consumers short of cash and reluctant to spend.

Will it work?

That depends.

The central banks are making $110bn of cash available, which will help banks in need of cash.

But it will not necessarily solve the underlying problem of exposure to the sub-prime mortgage sector.

Central banks cannot compensate for this lack of confidence simply by injecting additional liquidity
Swiss National Bank's Thomas Jordan

We still do not know what the full extent of losses are. Current total losses are more than $60bn.

Until it is clear what the full damage is and which banks are affected - which could take until the end of the first quarter next year - banks are unlikely to have the confidence to lend money to each other.

Even the Swiss National Bank said central banks alone could not resolve the issue.

"Central banks cannot compensate for this lack of confidence simply by injecting additional liquidity. On the contrary, the financial market participants themselves must take the fundamental steps needed to restore this confidence," the SNB's Thomas Jordan said.

Most analysts have welcomed the central banks' move, but some see it as an act of desperation.

If that view takes hold, it is unlikely to restore confidence and encourage banks to lend money to each other.

If last week's lowering of rates and this week's promise of cash auctions do not reduce money market rates, it is unclear what action central banks can then take.

Persistently high money market rates would raise the question as to whether central banks control the level of interest rates or whether that control has, in effect, been ceded to commercial banks.

Why does this matter?

It matters for a few different reasons.

Some homeowners' mortgage deals are linked to Libor - the London inter-bank rate - which has now fallen for the first time in more than a month.

If this rate reduction is sustained, their monthly mortgage payments should fall.

But if banks still prove reluctant to lend money to each other and consumers, that could lead to higher mortgage rates, greater defaults and a slowdown in the housing sector.

Realtor sign
The credit crunch has hit the US housing market

Already, there have been hundreds of thousands of repossessions in the US.

Banks that post losses are also more likely to shed staff.

Credit crunch, falling house prices and financial sector job losses all point in one direction - recession.

While the US is currently the hardest hit, as the world's largest economy, the impact of a contraction there will be felt far beyond its borders.

Were the central banks right to act?

As with all help offered to borrowers in trouble, the issue of moral hazard rears its ugly head.

Will banks be more willing to take risks in the future if they feel global central banks will bail them out?

Once the moment of crisis has passed, the main issues will be the future regulation of the banking sector, the loans that banks make and the debt they take on to their books.


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