Editor's note: The U.S. Federal Reserve, acting with other nations' central banks, took steps Wednesday to support the global financial system with a coordinated plan to lower prices on dollar liquidity swaps beginning on December 5, and extending these swap arrangements to February 1, 2013. CNN's chief business correspondent Ali Velshi takes a look at why they may have made the move and how it can help the struggling European banks temporarily.
This major coordinated global move was undertaken because a global credit freeze – the likes of which we haven't seen since just after the collapse of Lehman Brothers in Sept of 2008 – was looking entirely possible.
By way of background, the cost (or rate) for European banks to borrow dollars from other European banks has skyrocketed since May and, in some cases, banks haven't been able to borrow for short periods (overnight to three months) at all.
Under international banking rules, banks must end each day with a certain reserve. As a matter of course, they lend each other money through a largely automated system on a nightly basis to cover any short-term shortfalls. Increasingly, with fears that over-leveraged banks could have a "run on the bank" and the lending bank might not be repaid, banks are hesitant to make short-term loans to other banks. If they do, it's at a premium rate.
The net follow-on effect is that under-capitalized banks stop offering short-term credit facilities to their clients. (Think of how clothing purchases are financed: Retailers don't pay cash to suppliers – a bank pays the suppliers, then gets cash from the retailer as sales are made.) As clients find it more difficult to raise much-needed daily operating cash from banks, they need to immediately slash cash expenditures. Generally, the easiest way to do that is to lay people off.
In an attempt to stave off the consequences of a global credit freeze, the Federal Reserve, in coordination with major central banks, has created a credit line available to those central banks, whereby they can borrow dollars at reduced interest rates for periods of three months. The central banks, in turn, can lend to commercial banks in their respective countries. This is meant to reduce the cost of short-term borrowing for troubled European banks and to give them immediate access to dollars.
This was done immediately after the collapse of Lehman Brothers as well, to alleviate the consequences of banks being largely unwilling to lend to other banks, even for short periods, for fear that the borrowing banks could fail.
This is a serious development that doesn't solve an underlying problem of bank instability. It buys time for banks to try to find solid footing for themselves.
And, in case you were wondering, it is an instance of the creation of "moral hazard" - a term in economic theory for a situation where there's an incentive to share a risk – as the central banks have jointly decided that some shaky European banks may be "too big to fail."