Monday, August 20, 2007

European central banks on stand-by

From the FT this morning:

European central banks on stand-by

European central banks are standing ready this week to take further steps to ease the credit squeeze following the US Federal Reserve’s unexpected move on Friday to stem the turmoil in money and credit markets.

Financial markets rallied after the Fed made direct loans available to banks on favourable terms and hinted at an interest rate cut. If the move calms US nerves this week, European central bankers are likely to follow to ensure a similar effect is achieved across the Atlantic.

One policy lever the Europeans are considering is the extension of more credit to banks for longer periods than are normally available in an attempt to bring market interest rates closer to the central banks’ main interest rates.

Fed officials do not expect a quick recovery in credit market conditions, and another volatile week on the stock markets is thought to be in prospect.

Mohammed El-Erian, chief executive of Harvard Investment Management, said the Fed’s action had helped but more volatility probably lies ahead. The question was no longer whether the Fed was prepared to counter market disorder, he said, but “whether it is able to do so”.

The world’s central bankers are also nervous that their powers to stem this crisis of confidence are limited, as even good quality credit cannot find ready purchasers. One noted the veracity of a comment by a market observer who said in these circumstances, any action by a central bank “doesn’t affect s***”.

At the weekend, the fear of continued small financial bombs going off was heightened as Sachsen LB, a second German state-owned bank, was bailed out after Ormond Quay, its off balance sheet investment vehicle, failed to secure finance in the commercial paper market.

Also late on Friday, Sentinel, the US cash management group, filed for Chapter 11 bankruptcy protection after freezing its clients’ accounts last week.

Signs of banks’ difficulties in raising credit were evident at the end of last week when European three-month interbank rates were much higher, at 4.65 per cent, than the European Central Bank’s 4 per cent policy rate. The ECB’s actions so far only stabilised the very short-term overnight market.

In London, where the Bank of England has so far avoided any intervention, interbank rates were 6.3 per cent overnight and 6.7 per cent at a three-month maturity, well above the central bank’s 5.75 per cent main rate of interest.

Although the Bank of England is trying to avoid being the first port of call for banks, if unusual market rates persist, it would act to secure its objective for “overnight market interest rates to be in line with the Bank’s official rate”.

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