Analysis Brief

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Shoring up the Banking System

Author: Lee Hudson Teslik
December 19, 2007


It's not so often that central banks team up. This month, for the first time since 9/11, they did just that when the U.S. Federal Reserve, the European Central Bank (ECB), and three other major banks announced they would attempt to coordinate (Reuters) their responses to global credit concerns. The ECB and the Swiss National Bank said they would provide more loans in dollars (FT). The U.S. Fed, for its part, took a page from the playbook of several European central banks, setting up an auction facility (MarketWatch) through which banks can lend each other emergency funds. Commercial banks have expressed hesitancy about the process of taking short-term loans from the Fed's discount window—the place where such funds are ordinarily doled out—due to the public stigma and possible share price implications associated with taking a loan. The new scheme aims to better cloak the process, allowing banks that aren't at risk of collapsing—but need need short-term loans—to get them anonymously.

The news of the varying plans brought mixed reaction from economists. Martin Wolf writes in the Financial Times that "central banks must be pretty worried to take such a joint action." Wolf equates the plan to helicopters dropping cash from the skies, but adds that it could feasibly work out well—under very specific circumstances. Most significantly, he says, the money must be targeted specifically at boosting market morale by avoiding the bad press associated with borrowing. It should not be used to save insolvent banks. In a new interview, CFR's Roger M. Kubarych says that in theory the move is a "win-win situation" for banks. It's a confidence builder, he says, because it "dramatically reduces the risk" of actually having a run at a major bank—a crisis scenario that tends to spook markets, and which has already unfolded this year at one British bank (IHT).

So, after months of financial doom and gloom, is this finally an off-ramp for embattled banks? Probably not, experts say. Failing to find loans to satisfy intraday trading is only one way for a bank to fail. Other serious threats remain. Kubarych says banks are now far more concerned about their own balance sheets than the management of their reserves. Specifically, many banks fear they still have substantial holdings of bad debt, repackaged from shaky subprime loans that may yet implode. This fear now pervades the global banking system, not just U.S. banks. The majority of subprime loans may have originated in the United States, but the debt packages they were made into were bought up globally.

The widespread uncertainty this situation has caused in part undermines the original purpose of the Fed's auctioning plan—freeing up banks so that they, in turn, can give loans a little more freely. Until banks have a better idea what's on their own balance sheets, the Economist says, they will remain unlikely to go out on a limb with their lending. Yet the fact of other potential land mines doesn't mitigate the importance of stepping past the first. The hope is that the package could stave off the short-term lending crisis and allow banks to focus on their underlying finances. "But don't be fooled," the Economist piece concludes. "It is only a hope."

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