THE FED’S LIQUIDITY COST CUT

Q.WHAT IS THIS LIQUIDITY THAT’S BEING OFFERED?
A.The Federal Reserve offers dollars to other central banks, in exchange for their currency, at a fixed exchange rate. Those central banks – including the Bank of England – then lend it out to banks that need cash but can’t get it from the market.

Q.HAS IT BEEN ON OFFER BEFORE?
A.Yes. The liquidity programme was used heavily in the wake of Lehman Brothers’ collapse in 2008, when banks suddenly stopped lending to each other – they still had assets, but did not know who to trust with their money. So they borrowed from the central banks. The programme stopped being used as markets calmed down, but has been revived as the Eurozone crisis spreads and banks once again are less likely to lend to each other.

Q.WHAT DO THOSE BANKS DO TO GET THE CASH?
A.They must offer collateral – like US Treasury bills, for example – to borrow from the central bank. They must also pay a penalty rate on top of the usual market rate. Banks seeking help pay this penalty because the markets do not trust them enough to lend to them at a low enough rate, if at all, so this is the only way to get the money they need.

Q.WHAT HAS CHANGED NOW?
A.The penalty rate has been cut in half – from 100 basis points (one per cent) to 50bps. This shows the market that the central banks are prepared to lend more cheaply to troubled banks, making them less likely to collapse.

Q.WHAT WILL THE IMPACT BE?
A.The initial impact was that stock markets shot up, because they now see banks as a bit safer. In the longer run, UK banks will only benefit from the low cost – and be able to pass it on to businesses and individual customers – if they need help. It is more of a safety net, for now.