Central banks get together

The world's central banks are back. They're taking collective action again - all for one and one for all.

They learned back in December that co-ordinated action works better than individual action.

In any case, moving together at least prevents the stigma facing any one of them that takes individual action, which inevitably invites the question "What do they know? Things must be very bad on their patch."

But why have they all moved now?

Well, it is partly because the action they took back in September is expiring so it needed to be renewed.

But it is partly because the problems they "solved" back then have crept back. The LIBOR spreads - the best measure of the banks' reluctance to lend to each other - have been rising again (though they're not as high as they were last year).

At the same time, there has been a stream of bad news - rising delinquency rates in the US mortgage market, (and not just in sub-prime) worries about hedge funds, about an affiliate of the Carlyle Group, about Bear Stearns, and about a worsening economic situation... which all mean confidence is in short supply. The central banks are doing what they can to re-instil it.

What the central banks are doing is lending money to banks. These are secured loans - but they are secured against assets the borrowing banks possess. Unfortunately the assets are often the very ones other banks are themselves a bit wary of lending against (like mortgage-backed securities).

I'm not questioning the merits of lending against dodgy assets, although others might.

But it is worth questioning whether long term, the central bank action to lend money (albeit against assets that would otherwise be moribund) will work any better second time around than when it was tried last December.

Maybe, but maybe not. Here's the argument as I see it.

The evidence is that the credit crunch has been in two distinct phases - the first was a liquidity crisis, when banks needed cash to help them absorb their off-balance sheet affiliates which found they couldn't re-finance themselves as easily as they needed.

The central banks can provide liquidity - that's what they are designed for.

But that phase has passed. Since late October, we have been in a second phase of the credit crunch which has seen a reluctance for banks to lend to each other not out of liquidity shortages, but out of a general worry that the banks they lend to won't be able to pay them back.

It is, in other words, a crisis of confidence in bank solvency. It's not that banks don't have cash to lend; it's that they don't trust each other to have sufficient assets.

The problem with the central banks’ operations back in December and now, is that they don't really affect bank solvency, so don't have much effect on the underlying solvency worries.

To be more solvent, the banks don't need to borrow extra cash from the central banks, they need extra long-term capital from investors (from say, rich oil states, sovereign wealth funds, or the UK taxpayer).

Lending money doesn't affect the solvency at all, unless it props up confidence that would otherwise be lacking, or unless it injects an implicit subsidy to the borrower or unless it props up the value of some of the assets which the banks hold.

But the measures taken today are not designed to subsidise banks, or prop up the value of assets.

So the "active ingredient" the central banks themselves place emphasis on is the injection of confidence.

That may have a useful short-term effect.

It may stop confidence problems getting out of hand, with fears becoming self-fulfilling.

But long term, confidence will only have a sustainable effect on the solvency of our banks, if the confidence ultimately seems justified.

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