Central banks try to lift markets

Financial Times, last updated: September 16 2008 12:32

By Ralph Atkins in Frankfurt and Chris Giles in London 

Central banks across Europe intervened heavily on Tuesday morning, after much higher than usual volatility in money markets as banks scrambled for cash following the collapse of Lehman Brothers.

The European Central Bank reported a sharp rise in eurozone banks’ demand for liquidity and pumped €70bn of emergency funds into the overnight market – significantly higher than on Monday.

The Bank of England followed Monday’s injection of £5bn of cash until Thursday, with an additional £20bn on Tuesday.

The Federal Reserve Bank of New York said on Tuesday it would “shortly”’ arrange a “large” injection of funds into money markets after overnight interest rates surged.

Many commercial banks will be short of cash because they have exposures to Lehman Brothers that are now tied up in bankruptcy proceedings.

The signs of stress in unsecured bank funding markets were extreme. On Tuesday the overnight sterling Libor fix jumped to a seven-year high of 6.79 per cent as banks hoarded cash. The short term OIS market, more closely watched by the Bank, was also extremely volatile with short term interest rates trading well above the Bank’s 5 per cent policy rate.

The share prices of banks lurched lower on Tuesday as the signs of strain in the financial system increased. HBOS, the UK’s largest mortgage lender, was the biggest faller – down 28 per cent at 167.4p. That helped push the FTSE 100 index of blue-chip shares briefly below 5,000 for the first time since June 2005.

Other banks were also sharply lower. Barclays, which earlier on Tuesday said it was interested in buying parts of Lehman, was down 6.1 per cent at 296¾p and Royal Bank of Scotland was 11 per cent weaker at 187p.

Bids for overnight funds in the latest ECB special operation launched since the collapse of Lehman Brothers at the weekend exceeded €100bn, the Frankfurt-based institution reported. That pointed to rising financial market tensions in the wake of the US financial crisis.

In the end, the ECB allocated €70bn at an average interest rate of 4.4 per cent. But that was significantly higher than the €30bn it allocated on Monday, when the bank pledged, “to contribute to orderly conditions in the euro money market”. Its policy rate is currently 4.25 per cent.

Bids were equally high in London, with banks seeking £58bn compared with the £20bn on offer. In London the interest rate on the cash offered by the Bank of England was the 5 per cent policy rate as the Bank uses such operations to tide commercial banks over until their regular weekly refinancing operation on Thursday.

Then the Bank of England will estimate how much extra cash it needs to pump into financial institutions in the short term to ensure that overnight interest rates stay at its desired level of 5 per cent.

At the same time, the ECB reported the strongest demand this year for funds in its regular offer of seven-day funds. Some 533 banks bid for a total of €328.7bn – the highest since the special liquidity-boosting operations launched by the ECB at the end of last year. The ECB allotted €150bn.

Throughout the unfolding global financial market turmoil, the ECB and the Bank of England have drawn a clear distinction between such financial market operations, aimed at easing tensions in money markets and ensuring overnight interest rates stay close to their policy rates, and their main interest rate strategy designed to control demand and inflation in the economy.

So far there has been no sign of the ECB weakening its hard-line stance in combating inflation, which was confirmed at 3.8 per cent in August, by Eurostat, the European Union’s statistical unit. That was only modestly lower than the record 4 per cent reported in July.

The ECB aims to keep inflation “below but close” to 2 per cent. The ECB’s monetary policy stance is unlikely to change even if the US Federal Reserve cuts US official borrowing costs tonight, analysts said.

Mervyn King, the Bank of England’s governor, had to write a letter to the chancellor on Tuesday, explaining why UK inflation was so high at 4.7 per cent. He struck a tough tone insisting the Bank was even “firmer” in its belief now that the economy had to weaken significantly to bring inflation down.


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