There was plenty of volatility in the markets last week, but it was the kind that investors like best. Indexes around the world soared on Wednesday, with the Dow Jones Industrial Average having its best day since 2009. Central bankers in North America, Europe, and Asia had coordinated behind closed doors to provide liquidity support to the near-moribund lending markets in Europe. When credit markets dry up, very bad things happen to the economy, as we all saw in 2008. The not-very-technical term often heard in financial circles is “credit crunch”. Right now, many experts fear a credit crunch is looming in the Eurozone. It was that fear which drove the phone calls and emails between Washington, London, Brussels, Tokyo, and elsewhere. In this post, we will look at why credit crunches occur and what the central banks’ moves last week may, and may not, mean for markets and the economy in the near to intermediate term.

To a larger extent than many people realize, banking ultimately rests on the foundation of confidence – confidence in any given bank’s ability to prudently manage its portfolio of assets and liabilities, and confidence in the prevailing and prospective economic conditions. This post is not the place for a detailed discussion of fractional reserve banking, so here is the short version. At any given time, a bank is only in possession of a fraction of the total value of its outstanding obligations – obligations held by depositors, bondholders, and other creditors of the bank. This arrangement works just fine most of the time. And at the end of a business day, any bank that needs an immediate cash injection to keep its books in order can simply tap the overnight lending market, borrowing the funds and then repaying them the next day. The grease that oils this process is the short term money market, consisting of instruments like repurchase agreements, swap facilities, and commercial paper.

What has happened in Europe in recent weeks is reminiscent of what we saw in the fall of 2008. An adverse market environment threatens the ability of financial institutions to conduct their business-as-usual operations in the short term lending markets. Banks’ balance sheets deteriorate with toxic assets, such as subprime loans and Greek sovereign bonds, and lenders do not want to provide them short term liquidity for fear that tomorrow may be the day when their counterparty defaults. When these markets dry up, it affects everybody. Workers cannot cash their paychecks and businesses cannot pay their suppliers.

Although the details remain murky, some market sources say that a credit crunch of this magnitude was about to rock the markets last week, until the powerful display of coordination between the central banks calmed investors’ jangled nerves. The focal point of this intervention was a swap facility between the US Fed and the European Central Bank – a facility the ECB uses to provide dollar-based lending to European banks. By reducing the cost of this facility, the Fed and the ECB essentially made it possible for Eurozone banks that could not access their normal market sources to obtain short term funds and avoid (for now, at least) the prospect of being unable to fund their routine obligations. The immediate impact of this decision – and the magnitude of the reality – was made clear by the fact that banks immediately tapped the facility for over €8 billion on the first day it was made available.

As impressive as this action appears, the story is not over. First of all, the central bank action does nothing to “bail out” either banks or sovereign nations. Greece, Italy, and the rest are still in dire condition, although yields on their debt have come down somewhat in the last two days. Second, there are questions about how open-ended this swap facility can be, particularly in regard to how much more the Fed can swell its balance sheet without drawing political fire in Washington. On both sides of the Atlantic, policymakers are aware that actions have political consequences – as does inaction.

If and when policymakers and financial institutions are able to show that the single currency union will remain intact and that systemically critical defaults among large banks will not take place, then we will likely see genuine confidence return to European asset markets. Until then, the outcome remains anybody’s guess, and investors should continue to tread with caution.

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