European Central Bank scrambles to head off potential financial crisis...
Copyright The Financial Times Limited 2007

The European Central Bank scrambled to head off a potential financial crisis on Thursday by pumping an emergency €94.8bn ($131bn) into the region’s banking system after liquidity in the interbank market started to dry up, threatening banks’ access to short-term funds.

The cash injection was the biggest in the ECB’s history, exceeding the €69bn provided the day after the terrorist attacks of September 11 2001. The ECB also made an unprecedented one-day pledge to meet 100 per cent of all funding requests from financial institutions.

The ECB action followed a sharp increase in the rate at which banks are prepared to lend overnight to each other. It was designed to ensure that money markets continued to function.

The rise in the interbank rate swiftly spilled over into the US. The Federal Reserve did not implement any emergency steps, but put an unusually large $24bn into US markets in scheduled open market operations.

The Bank of Canada, meanwhile, issued a rare statement in which it pledged to “provide liquidity to support the stability of the Canadian financial system and the continued functioning of financial markets”. Reuters reported that the Bank of Japan injected 1,000bn yen ($8.45bn) in funds in its regular money market operation Friday after a slight rise in the benchmark overnight call rate to a reported high of 0.54 percent. The Reserve Bank of Australia in turn injected A$4.95bn into the system through repurchase agreements. The Bank of Korea said it stood ready to inject funds as well.

The moves by the central banks succeeded in bringing down the overnight interbank lending rates to more normal levels, though the US federal funds rate remained above its target in late trading.

Stocks plunged and government bonds jumped as investors sought safety in low risk assets. The yield on the two-year Treasury fell 22 basis points to 4.44 per cent. Yields on 30-day commercial paper rose 5 basis points to 5.32 per cent, equalling its highest rate since 2001.

Brian Sack, senior economist at Macroeconomic Advisers, said: “What happened today raises more systemic risk issues. It had a feel of liquidity problems similar to some of the past episodes like 1998...I am not saying it is as intense as 1998, but it certainly looked like that.”

The Dow fell 2.83 per cent, while the UK’s FTSE lost 1.83 per cent, Germany’s DAX index fell 2 per cent and France’s CAC-40 fell 2.17 per cent.

The ECB did not offer a detailed explanation for its move, which surprised markets, but simply said it was now seeking to “assure orderly conditions in the euro money market”.

Ed Marrinan, head of credit strategy at JPMorgan, said: “This appears to be a prudent, pre-emptive step to head off any possibility of liquidity problems.”

It came as BNP Paribas, second biggest bank in the eurozone, froze access to three funds.

Marc Ostwald, fixed income strategist at Insinger de Beaufort, said: “There is huge pressure on money rates due to an apparent sense of mistrust. Following BNP Paribas’ statement, very few institutions appear willing to lend.”

The $24bn injected into US markets by the New York Fed came in two scheduled open market operations

The total is roughly double the normal amount the Fed lends to the markets, but is not remarkably high and suggests the Fed is not in outright crisis fighting- mode.

Some traders warned that market unease was unlikely to dissipate soon. Edwin Rood, global head of money markets at ABN Amro, said: “The underlying problem cannot be addressed directly by the ECB.”

Additional reporting by Michael Mackenzie, Paul J Davies, Chris Flood and Richard Beales

Copyright The Financial Times Limited 2007