The Bank of England made its first intervention in the credit crisis yesterday, easing its terms for lending to banks in an attempt to unfreeze the short-term money markets as banks increased their targets for reserves.
The Bank encouraged banks to borrow from it if necessary by relaxing penalties if they miscalculate their requirements and pledged to inject up to £4.4bn into the system if needed.
Money markets have seized up as banks and investors have been gripped by panic after defaults on securities linked to US mortgages caused massive losses for banks in the US, Germany and elsewhere. Scared of where losses will turn up next, banks have been unwilling to lend to each other, sending interest rates on previously routine loans rocketing.
"The increase in reserves balances should help to relieve some pressure on interest rates for overnight borrowing, which have ... been unusually high relative to bank rate," the Bank of England said.
The country's banks increased their aggregate reserve target by 6 per cent to £17.63bn, about £1bn more than the top of the range over the previous six months. The increase will reduce their need to borrow from each other or tap the Bank's emergency facility, which has caused panic in markets in recent weeks.
The Bank insisted it was maintaining its hard line on not bailing out financial markets for lax lending amid the credit frenzy that crashed to a halt last month. The European Central Bank and the US Federal Reserve have both gone further by injecting money into the system or cutting the rate at which they will lend to banks.
The Bank is targeting the overnight rate, which had jumped higher than its normal position just above base rate, but says its actions are not designed to unfreeze the longer-term, riskier, commercial paper market.
Overnight BBA libor fell from 6.11000 per cent on Tuesday to 5.906 yesterday, but the three-month Libor was stuck at a nine-year high of 6.8 per cent.
But some Bank watchers said that, while sticking to its guns, its actions would help renew banks' appetite for longer-term lending.
"More liquidity at the short end will gradually drift up to the longer end," Geoffrey Wood, the professor of economics at Cass Business School, said. "They are making sure there is no harmful panic without creating moral hazard – it's a nice bit of work."
The 313-year-old central bank's hands-off stance has come in for criticism as paralysis in the money markets has increased. It has also refused to comment on the use of its standby loan facility, prompting Barclays to issue a statement last week when a technical glitch caused it to tap the facility for the second time in a fortnight.
Some economists thought the Bank should have gone further but that the move would help ease concerns that it was too aloof.
"People have been saying the lights are on but no one is home, raising concerns they weren't prepared to step in on any grounds to save the market," Gavin Redknap, the UK economist at Standard Chartered, said. "They have at least said something about what is going on and perhaps marginally added to liquidity."
The reserves are current accounts that each bank holds with the Bank of England for their day-to-day funding, on which they are paid base rate.