How the Central Bank Credit Plan Will Work

Major central banks, including the Federal Reserve and the European Central Bank, acted in
unison Wednesday in unveiling plans to provide liquidity to the banking system, where funds covering a longer span of time have become scant.

Following are how the measures work and what the central banks are attempting.

Q. Who is involved?

A. The Bank of Canada, the Bank of England, the European Central Bank, the U.S. Federal Reserve and the Swiss National Bank announced liquidity measures. The Bank of Japan and the
Swedish Riksbank made separate statements welcoming those steps.

A decision for a coordinated announcement was made last week. The concerted effort was to reassure markets that central bank liquidity will be available for banks.

Q. What are the central banks going to do, and why?

A. The central banks are attempting to provide funds more broadly and at easier terms, while pinpointing the needs of term funding where rates remain elevated.

The central banks are aiming to alleviate upward pressure on rates for term interlink lending -- funds that banks lend to each other in the money market covering a longer span of time,
such as one to three months.

The Fed will set up a new auction facility that will provide up to $40 billion in two auctions by the end of the year. Two more auctions are scheduled for January and are open to all depository institutions able to borrow at the Fed's discount window.

The ECB will conduct two U.S. dollar tenders of up to $20 billion in connection with the Fed's action, against ECB-eligible collateral. The BoE will offer a bigger amount of funds and widen
collateral at upcoming scheduled auctions.

The Bank of Canada will offer funding covering the year-end and loosen restrictions on collateral by including provincial bonds, and bank-sponsored asset-backed commercial paper and U.S. Treasuries in the future.

Q. Why has a foreign exchange swap facility been set up by the Fed?

A. To provide for dollar funding needs by European banks, the Fed established foreign exchange swap lines of $20 billion with the European Central Bank and $4 billion with the Swiss National Bank for up to six months.

The currency swap agreement will give European banks more access to dollar funds. Dollar funding needs by European banks has been a major reason that rates were rising in the U.S.
money market.

Currency swap agreements were set up with the ECB, the BoE and Bank of Canada shortly after the Sept. 11, 2001 attacks, but went untapped.

Q. What is the likely impact of the plan?

A. Those hoping for the Fed to prop up the banking system more widely may be disappointed. It remains unclear whether the actions will ease lending conditions in the broader markets.
The Fed official said it had no benchmarks for success and that the measures were more of a backup and a reassurance that markets had another source of liquidity.

The actions on Wednesday indicate a temporary broadening of liquidity in the banking system, rather than a permanent injection of funds.

Several central banks, including the Fed and the BoE, have said the new funding would not change the overall balance of reserves and these new injections would offset some of the
projected year-end funding, in a different form.

Q. Why didn't the Fed just lower the discount rate?

A. A senior Fed official briefing reporters on Wednesday said the closing up of the spread between the discount window and the federal funds would make it difficult for the central
bank to calculate how much reserves it needs to provide through its open market operations.

It felt the new facility was a cleaner, better way of getting credit to banks.

The new facility will not disclose the names of the bidders, and the Fed hopes banks will be more comfortable if they can raise funds through an auction process.

Although the Fed had reduced the spread between the discount rate and the federal funds rate to 50 basis points from 100 basis points in August, banks have been somewhat reluctant to borrow because it is seen as a sign of last resort.

The 50-basis-point spread has been maintained since the Fed cut short-term interest rates by a full percentage point since mid-September.