Ten days of secret planning to rescue markets

Britain orchestrated this week’s bold move by central banks to stave off a cash crunch in global markets, helping drive a plan that began to take shape around 10 days ago.

For months, central bankers have tracked with growing concern how the deleveraging among European banks, hurt by the tumbling value of euro-zone debt, was hurting global funding as banks sold off assets and brought cash back home.

Indeed, some central banks had urged the Federal Reserve for some months to put in place cheaper dollar funding, but the Fed had resisted, said a source with direct knowledge of this week’s deal.

Last week, conditions grew particularly acute after a German bond auction failed to attract enough buyers. The Federal Reserve and the European Central Bank started serious discussions around the middle of last week, banking officials in Europe and the United States told Reuters.

Bank of England Governor Mervyn King said he called the meetings that led to the decision by six of the world’s major central banks to cut dollar funding rates to keep money flowing through the world’s financial arteries.

“It was the result of conversations which I initiated as chairman of what used to be known as the G10 governors, now the economic consultative committee, among a limited number of central banks,” he told a news conference in London on Thursday.

The decision by the U.S. Federal Reserve, the European Central Bank and the central banks of Japan, Canada, Britain and Switzerland to provide cheaper dollar funding for banks eased credit strains and provided a fillip to market sentiment.

Short-term funding costs eased on Thursday for the first time since July 22, when the latest phase of the euro-zone crisis took hold after European Union leaders failed to lay out detailed plans for a strong bailout fund. <MMT/>

Several banking officials said there was no specific trigger for the action, and specifically denied rumors that a European bank was on the brink of collapse. Instead, they characterized the action as the culmination of many weeks of worry as financial strains had built.

“Non-Europeans are not just complaining about the lack of action by Europeans but starting to feel more strongly that Europe can’t contain this problem by itself,” said a source briefed on the central bank discussions. “That sense might have led to this swap deal.”

Even emerging markets, notably Eastern Europe and Asia, were feeling the pinch as European banks pulled back lending operations and put assets on the block, two banking officials said. Local banks that took up the slack had less access to dollar funding for their clients, bank officials said.

In the announcement, the six central banks said they also were ready to make money available in currencies other than their own, if necessary.

“They wanted to ensure that a dollar crunch did not brake economies in Asia, in the United States,” said Austrian Finance Minister Maria Fekter.

FRATERNITY

Central bank officials from leading economies are in constant contact. They have cemented close relationships at the face-to-face meetings they hold every couple of months in Basel to exchange intelligence on financial markets and the economy.

After the ECB and the Fed discussed conditions last week, the Fed’s policy panel held a video-conference on Monday and agreed to cut the interest rate on its dollar swap lines.

Another source said provisional agreement was reached in a teleconference at the start of last week, and that by the end of the week, details had been agreed and the date of November 30 set for the announcement.

It wasn’t the first time central banks, including the Bank of Japan and the ECB, had approached the Fed about a cheaper dollar swap, a source said.

“Other central banks have been urging the Fed to put this arrangement in place for some time but Fed didn’t say ‘yes’ up till now,” said the source, who has direct knowledge of the arrangement.

“The Fed said ‘yes’ this time probably because the euro zone crisis developed into a global problem.”

The ECB has been watching the creeping credit freeze with growing alarm for more than half a year but its interventions — lending banks in the euro zone half a trillion euros — have failed to defeat fears they could be sucked under by the region’s sovereign debt crisis.

Two years into Europe’s crisis, investors are fleeing the euro zone bond market, European banks are dumping government debt, deposits are draining from southern European banks and a looming recession is fueling doubts about the euro’s survival.

Fed officials have been quick to point out that the cheaper dollar swap lines, intended to ensure banks outside the United States have ready access to dollars, are not intended to bail out Europe — but to help shore up economic growth.

“There is not so much leverage out there in the market right now, so if we do see the banking system freezing up, you might not see much forced selling, but it would impact the global economy in a very big way,” said Kathleen Gaffney of Loomis Sayles, a part of Natixis Asset Management.

EUROPEAN RETREAT

With dollar funding strains compounded by regulatory pressure, European banks have preferred to shore up balance sheets rather than fork out for dollar funding.

But most large banks also have dollar assets and liabilities. With interbank rates rising as concerns grow about the funding ability of counterparties, European banks have been effectively cut out of dollar markets. This has already prompted some European banks to dispose of U.S.-denominated assets — and sparked concerns that trade with the United States could be at risk.

Andrew Cole, investment director at Baring Asset Management, said the so-called TED spread — the difference between interest rates on interbank loans and short-term government bills — had been flashing warning signals.

“This is still a long way from the very high levels seen when Lehman Brothers failed, but has been moving steadily higher in recent months and is indicative of the concern about bank credit ratings, which has been impeding both interbank lending and lending in the wider economy,” Cole added.

The crisis has already prompted European banks to halt lending and start selling assets. But they are particularly keen to dispose of assets in U.S. dollars, where funding is most tight, seeing them pull back in areas like project finance, shipping finance, aviation and infrastructure.

For banks with big U.S. operations, or which tend to lend for projects denominated in dollars, like the French banks, this has been a particular problem.

Dollar funds have been made available via the ECB, but they are expensive and tapping the central bank carries stigma.

The funding crunch in Europe is far greater than simply a dollar issue, however, as banks in Europe’s crisis hotspots such as Greece have found themselves shut out of the interbank market needed to fund their day-to-day operations.

Even getting access to backstop funding options, such as ECB funding facilities, is becoming a problem as banks fret about running out of eligible securities they can use to tap these, or collateral. Banks are busy hoarding what securities they can to cash in at the ECB.

“This is Lehmans, take two. Cubed,” said Gaffney.