Central banks move to shore up financial system

The central banks of the major industrialized economies moved quickly on Monday to shore up the ailing global financial system in the wake of the seismic restructuring among Wall Street banks and brokers houses that took place the same day.

The central banks of the major industrialized economies moved quickly Monday to shore up an ailing global financial system in the wake of the seismic restructuring among Wall Street banks and brokers houses that took place the same day.

The European Central Bank [ECB], the Bank of England, the United States Federal Board and the Bank of Canada have all either offered up extra cash for debt-heavy financial service companies to borrow, or relaxed the collateral requirements that would allow these firms to access existing cash from central banks. 

These moves will give firms, faced with huge outstanding borrowing, a pool to additional capital to cover their debts.

On Monday, U.S. brokerage firm Lehman Brothers slipped into bankruptcy and venerable investment house Merrill Lynch & Co. was bought out by Bank of America Corp., both moves the result of large losses in the mortgage-backed commercial paper market.

Lehman Brothers' bankruptcy forced central banks to inject cash into the global financial system. ((Jin Lee/Associated Press))

Earlier this year, Bear Stearns was taken over in a similar financial rescue as the brokerage firm faced a debt-related bankruptcy, again driven by bad mortgage-backed investments.

As the crisis among investment houses grew, analysts were concerned that companies, such as giant insurer American International Group Inc. [AIG] reportedly seeking as much as $40 billion US to recapitalize its balance sheet, would not be able to find sufficient available cash to avoid bankruptcy.

Central bank moves

Last week, the ECB renewed an outstanding credit facility worth in the range of $106 billion, a sign that the central bank wanted to increase existing liquidity available to financial institutions.

In addition, the ECB said Monday it received $127 billion worth of bids for its available short-term cash, a signal of strong demand for the money among private-sector firms.

In a brief statement, the bank said it "stands ready to contribute to orderly conditions in the euro money market."

Similarly, the Bank of England offered $9 billion in short-term cash but received almost five times that amount, or $43 billion, in bids, another signal of the desperate scramble among the financial sector for cash. 

Also on Monday, the U.S. Federal Reserve said it would allow mortgage-backed paper to be used as collateral for firms borrowing from the central bank. Previously, the U.S. Fed forced companies to pledge investment-grade securities in return for borrowing its cash.

The Fed move followed a similar shift by the Bank of Canada last week. Canada's central bank relaxed the type of assets it would accept from financial companies accessing its cash pools.

Finally, on Sunday, a global consortium of 10 banks announced a pool of $70 billion to lend to troubled financial companies.

All of these measures are designed to give lenders confidence that companies faced with high levels of asset-backed commercial paper will have access to sufficient financial reserves to be able to keep their doors open.

Without such reassurances, lending institutions might be tempted to call in their outstanding loans in an effort to get their cash out of the ailing company before a bankruptcy.