Cavalry to The Rescue?

One of the roles of central banks is to be lenders of last resort. This was evident on Friday.

The world's central banks opened the spigots releasing US$120bn to keep liquidity flowing to commercial banks thirsting for credit. The European Central Bank, in particular, opened the flood gates releasing US$84bn, following from the record US$130bn the previous day. It then went public saying it would make available what ever liquidity was necessary.

Investors sensing a major problem responded by giving global equity markets another pounding as they rushed for the relative safety of government bonds.

For the ECB, discretion would have been the better part of valour. Investors hang on every sentence, word, full stop, comma and nuance ushered by the leading central bankers.

All market participants know central banks will take the necessary steps to safeguard the integrity of the financial system – it's their job. Under circumstances of heightened market nervousness such problems are best worked out discreetly in the background.

What a marked contrast to the measured and more reassuring statements from the Federal Reserve last Tuesday and then the Bank of England on Wednesday.

It is becoming evident that the sub-prime crisis is causing considerable damage.

Regular stories are emerging of one hedge fund after another twisting on the ropes and banks struggling with high loan exposures. Apparently, they have billions of dollars of corporate bonds on their balance sheets, which they need to fund.

The trouble with the current correction is that it is effecting other asset classes, such as equity and loans – which may not be prime – but are not about to default.

Banks have other loans outstanding against these deflating assets and the danger is that the current correction will be transformed into an all out crash as credit lines and the like are reassessed and even pulled.

This would massively exacerbate the liquidity crisis. It wouldn't be long before the real economy starts hurting. Even oil was about 10% off its highs on Friday.

It would certainly spell an end to the current M&A wave.

But before that happened, the Fed would be likely to respond with a rate cut i.e. a massive injection of liquidity to keep the wheals of the financial system turning.

It would hopefully send out hoards of investors – many from emerging markets – on a huge bargain hunting spree. In the meantime, banks would feel more comfortable about the assets backing their loans.

The events of last week have increased the probability of a rate cut.

A few more weeks of heavy falls in equity markets, central banks may be forced to intervene on a massive scale with Ben Bernanke at the head of the cavalry charge to relieve besieged banks.

Once back to normal, the fight against inflation can resume.