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The Real Reason Behind the Central Bank Scramble

Stocks in this article: GS JPM MS C BAC

Calling the move a program to "support the global financial system," the Federal Reserve indicated that the real issue was banks borrowing dollars. As a result, it extended currency swap lines to offer foreign central banks dollars through February 2013. The move, and a statement from the Fed signaled that the real pressure arose abroad. "At present, there is no need to offer liquidity in non-domestic currencies other than the U.S. dollar," the Fed said in a statement.

Similar swap arrangements were opened in May 2010 at the outset of the European sovereign debt crisis and in 2007, as the sub-prime mortgage crisis worsened. In all instances, the swap lines help banks fund foreign currency denominated debt, primarily in dollars.

In a statement the Federal Reserve said that further details will be forthcoming and that "were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses."

In an interview with Bloomberg, Canadian Finance Minister Jim Flaherty said that the coordinated central bank move wasn't targeted at a single financial institution.

After the move, some markets showed signs that the move was timely. Stock markets rallied around the world, with shares of many European banking stocks like Deutsche Bank (DB) rising over 10%. Citigroup (C - Get Report) rose over 8% and Morgan Stanley (MS - Get Report) climbed more than 11%, meanwhile Bank of America shares gained more than 7%.

In funding markets, the move also showed promising signs. The cost for European banks to borrow dollars fell from three year highs, and yields on sovereign debt in Italy and Spain fell from near-record highs.

According to press reports, the emergency arrangements were agreed on in a Nov. 28 vote, where 9 Fed officials agreed to the measures, while Jeffrey Lacker president of the Richmond Fed dissented.

Still, the long term impact of the move is uncertain, as were similar moves in 2007 and 2010, which didn't prevent an escalating bank crisis entirely.

Bank of Japan governor Masaaki Shirakawa told reporters in Tokyo that "the European sovereign debt problem will not be solved only with liquidity," citing the need for the European countries to continue with economic reforms.

Meanwhile, Jayan U. Dhru, the global head of S&P's bank ratings practice told reporters and analysts in a Wednesday call that the firm's widespread re-appraisal of risk to financial institutions stemmed, in part, from increased sovereign debt risks and the drag they may pose to bank earnings, capital assessments and potential future bank bailouts or debt guarantees. Of funding markets nearing post-crisis highs, Dhru said, "fear is overwhelming fundamentals. We have seen this movie before."

Dhru said that Tuesday's cuts, in addition to previous negative changes to the ratings of the largest banks in France and Spain make the firm's stance on the risks to banks well positioned for a potential worsening in markets.

-- Written by Antoine Gara in New York

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