WASHINGTON — Banks squeezed by a global credit crisis have a new way to get their hands on cash so they can keep making loans to individuals and businesses. The Federal Reserve, under pressure to take more aggressive action, unveiled a plan Wednesday designed to bring banks and their borrowers relief.
Some questions and answers about what the Fed is doing:
Q: Why is the Fed taking this action?
A: The credit crisis has unhinged Wall Street and threatens to hurt the U.S. economy, which is fighting to avoid a recession.
Q: Why are banks having problems?
A: A meltdown in the housing and credit markets has made banks and other financial institutions reluctant to lend to each other, causing a cash crunch. Banks have to maintain a certain level of cash reserves, which changes every day. During normal times a bank, on some days, may be short on its reserves and would need to borrow from another bank to make up the difference. Or a bank may have excess reserves, which it is willing to lend to another bank. Now, however, many banks have been hoarding cash, not wanting to lend or borrow from others banks. That makes it harder and more expensive for individuals and businesses to obtain credit from banks to finance all sorts of things.
Q: Why are banks reluctant to lend to each other?
A: The collapse in the subprime market, home loans made to people with tarnished credit or low incomes, triggered the credit crisis. Banks, financial companies and other investors who made subprime loans or put money into securities backed by those subprime mortgages have lost billions of dollars. Investors in the U.S. and abroad have grown more wary of buying new debt, thereby aggravating the credit crunch.
Q: How does the Fed's plan help?
A: At the heart of the Fed's plan is the creation of a new temporary facility to provide banks with at least $40 billion in emergency loans. The Fed is trying to shore up the finances of the banking system.
Q: And how will that help individuals and businesses?
A: If banks have adequate cash on hand, they may be more likely to make loans to people and businesses that need them. The free flow of credit is the economy's lifeblood. It allows people to make big ticket purchases and businesses to build and expand. The plan won't have an immediate impact on the availability and cost of credit to individuals, but it should help over the course of the coming weeks, analysts said.
Q: How does the core of the plan work?
A: The Fed's facility will lend $40 billion in emergency funds to banks through two auctions next week, on Monday and Thursday. Banks needing cash and that are judged to be in "generally sound financial condition" can participate. Banks place bids to get a slice of the money.
The loans are expected to be at rates lower than the 4.75 percent the Fed currently charges banks for direct loans. To secure the short-term, 28-day loans, banks can pledge a broad variety of collateral, such as corporate bonds and loans.Q: Why set up this new, temporary facility if cash-strapped banks already have the option of going to the Fed's discount window for an emergency loan?
A: Tapping the Fed's discount window can put a stigma on a bank if word gets out. Analysts say it is akin to getting branded with a financial scarlet letter.
Ever since the credit crisis intensified in August, the Fed has been working to remove that blot.