A coordinated move by leading central banks to grease the wheels of the global banking system is likely to be followed by other steps to prevent the euro zone debt crisis from triggering a full-blown credit crunch and economic recession. Success is far from guaranteed.
The longer the crisis festers, the greater the risk of accidents such as a failed bond auction that could touch off a market panic or a bank run.
Wednesday's cut by the European Central Bank (ECB), the Federal Reserve and four other central banks in the cost of existing dollar swap lines is not the 'big bazooka' needed to support tottering bond prices and quash speculation of a break-up of the 12-year-old single currency.
But it will help euro zone lenders that have been cold-shouldered by investors such as U.S. money market funds fearful that the banks will topple under the weight of their exposure to now-dodgy sovereign bonds and be unable to repay their loans.
It gives an indication that monetary authorities are prepared to do what is required to stop a freeze-up in the funding markets, said Michael Hewson, an analyst at CMC Markets in London.
And by applying balm to the markets, it buys time for euro zone policy makers to thrash out a deal to put the single currency on a more solid long-term footing and extend a financing lifeline to the likes of Italy and Spain.
This move by the central banks is a necessary, but not a sufficient element, to solve the crisis. The market is waiting for a political solution. But it's good that policymakers have started to cope with the problems at the money market -- the situation had worsened lately. It's a signal at exactly the right time, said Max Holzer, head of asset allocation at fund manager Union Investment in Frankfurt.
A TRUE FINANCIAL CRISIS
Recent months have provided a textbook example of how problems in one corner of today's interconnected markets can mutate into what ECB Governing Council member Christian Noyer on Wednesday called a true financial crisis -- that is a broad-based disruption in financial markets.
Loss of confidence in the ability of several euro zone governments to service their heavy debts at an affordable cost has infected banks, which are big owners of sovereign bonds.
With banks in turn reluctant to lend to each other, various measures of stress in the money markets have risen to levels not seen since late 2008 or early 2009. As a consequence, demand for funds from the ECB has soared to a two-year high. Moreover, unsecured term funding is also all but impossible, bankers say.
As their cost of funds rises, banks are charging borrowers more and lending less, surveys show.
To meet the demand of regulators that they increase their core capital to 9 percent of risk-weighted assets by mid-2012, European banks are rapidly reducing their lending because few can raise fresh equity or are willing to do so while their share prices are depressed.
Some banks are pulling out of peripheral markets -- French lender Credit Agricole on Monday announced its withdrawal from South Africa -- while others are exiting particular sectors. One London banker said the European market for project financing was effectively frozen.
With credit tightening, the economic picture is darkening. Because a downturn or recession would sap tax revenues, further squeezing government budgets, pressure on euro zone bonds increases and is in turn transmitted to banks.
The vicious circle takes another turn.
As if things were not bad enough, the downgrade of 15 big banks' credit ratings by Standard and Poor's risks increasing their funding costs and forcing them to put up more collateral for their trading activities.
Collateral is already scarce for Europe's cash-strapped banks, which have started paying institutional investors to swap illiquid bonds in exchange for better quality ones in order to secure cash from the ECB.
With lower ratings, counterparty risk goes up and so do margin calls, so it does make it more difficult, said Carlo Mareels, a credit analyst at RBC Capital Markets.
Against this background of stress, the ECB would do whatever was necessary to ensure adequate financing is available for companies and households, Noyer, the Bank of France governor, said.
In a period of intense market disruption, it is essential to ensure that the monetary policy transmission mechanism actually works. This may involve temporary and exceptional interventions on those market segments where dysfunctions are most apparent, he said in Singapore.
Economists say the next steps from the ECB at its December 8 policy meeting could include an interest rate cut; an offer to lend banks as much cash as they want for two or three years because market financing beyond two years is prohibitively expensive; and a relaxation of the rules governing the collateral banks must pledge against such loans.
Nick Kounis, head of macro research at ABN AMRO, is among those expecting fresh help next week. But he said the drive to ensure the banking system is liquid was not a game changer for the debt crisis.
It's relieving some strains, but it's not meant to tackle the actual sources of these problems, Kounis said. Policy makers were still quite a way from devising a credible package.
Central to any such package, many economists believe, will be the big bazooka -- the emergence of the ECB as a lender of last resort for the euro area to avoid a disorderly default by a big country such as Italy that could cause the collapse of much of the European and U.S. banking system.
We are pretty sure that will happen at some stage, said Juergen Michels, an economist at Citi in London.
But he said four conditions would have to be met before the ECB dropped its opposition to backstopping euro area sovereigns:
- more market pressure, for instance in the form of a failed bond auction by Italy or Spain.
- evidence from weaker states that they are seriously implementing austerity measures to reduce budget deficits and structural reforms to address low growth and productivity.
- a commitment from donor/creditor countries such as Germany to provide more firepower to the euro zone's rescue fund and/or credible steps towards medium-term fiscal integration.
- strict fiscal governance rules, including automatic penalties for budget busters.
Once these are met they're likely to go ahead with more supportive action, Michels said.
If he's wrong, the funding strains that prompted Wednesday's concerted central bank action could prove to be the precursor of something much more dramatic: the break-up of the euro.
The economic and monetary union will either have to be completed through much deeper integration or we will have to accept a gradual disintegration of over half a century of European integration, the European Union's economic and monetary affairs commissioner, Olli Rehn, told the European Parliament.
(Additional reporting by Philipp Halstrick and Kathrin Jones in Frankfurt, Douwe Miedema and Atul Prakash in London, Gilbert Kreijger in Amsterdam and Jan Strupczewski in Brussels; editing by Janet McBride)