Central banks cool money market rates

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The Independent Online

Central banks appear to have had considerable success in restoring activity to the credit markets, according to evidence yesterday.

The interest rates at which banks are willing to lend to each other fell sharply in some cases recording their biggest drops in four years as the caution that had threatened to paralyse the financial system abated. The Federal Reserve in the US, the Bank of England and the European Central Bank have all injected additional liquidity into the financial markets, by auctioning loans that will tide banks over into the new year. The Fed said yesterday that its $20bn (10bn) auction on Monday had been two-times oversubscribed and attracted 93 participants, and that it would press ahead with another auction of the same size today.

The bidding on the first auction was such that the interest rate was set at a higher than expected 4.65 per cent. "Banks obviously found this to be a useful source of liquidity and were willing to pay well above the minimum to get it," said Kevin Logan, chief US economist at Dresdner Kleinwort.

Banks have been hoarding cash before 31 December, a vital date in the accounting calendar, when many may have to put up additional collateral to cover outstanding liabilities. With so much uncertainty about funding needs at that point, banks have been unwilling to lend to each other, and that has had knock-on effects across the markets. A wide variety of businesses have found it harder and more expensive to find the cash to fund their operations. As well as the Fed's $20bn cash injection, markets were also continuing to feel the effects of Monday's injection of €348bn (250bn) of loans by the ECB.

Investors were cheered by big declines in Libor, the London inter-bank lending rate. Three-month sterling Libor fell to 6.21 per cent from 6.39 per cent, its big-gest decline since September. One-month sterling Libor had its biggest single-day drop since February 2003.

However, there were reminders that the credit crisis is still to fully play itself out. One of America's largest bond insurers, ACA, had its debt rating cut to junk status because of losses on sub-prime mortgage-related bonds, and Standard & Poor's, the rating agency, threatened to downgrade other bond insurers, too.

Meanwhile, the Financial Services Authority in the UK is planning to impose tougher liquidity tests on banks.

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