Central Banks and the Credit Crunch of 2007

The global credit crunch induced by the subprime mortgage crisis in the United States,Central Banks and the Credit Crunch of 2007 Articles in the second half of 2007, engendered a tectonic and paradigmatic shift in the way central banks perceive themselves and their role in the banking and financial systems.

On December 12, 2007, America’s Federal Reserve, the Bank of England, the European Central Bank (ECB), the Bank of Canada and the Swiss National Bank, as well as Japan’s and Sweden’s central banks joined forces in a plan to ease the worldwide liquidity squeeze.

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This collusion was a direct reaction to the fact that more conventional instruments have failed. Despite soaring spreads between the federal funds rate and the LIBOR (charged in interbank lending), banks barely touched money provided via the Fed’s discount window. Repeated and steep cuts in interest rates and the establishment of reciprocal currency-swap lines fared no better.

The Fed then proceeded to establish a “Term Auction Facility (TAF)”, doling out one-month loans to eligible banks. The Bank of England multiplied fivefold its regular term auctions for three months maturities. On December 18, the ECB lent 350 million euros to 390 banks at below market rates.

Interest rates for most lines of credit, though, were set by the markets in (sometimes anonymous) auctions, rather than directly by the central banks, thus removing the central banks’ ability to penalize financial institutions whose lax credit policies were, to use a mild understatement, negligent.