maxdimario wrote on Thu, 17 January 2008 20:53 |
do these loans permit banks to increase credit?
in other words, why would a central bank loan money for one day?
what effect would it have?
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Economies work by moving money around, it's always moving around. Every day banks that are short of cash (not assets, but actual liquid cash), borrow from those that have excess... often just overnight.
When you get an event like the sub-prime mortgage fiasco, one thing is guaranteed to happen, and that is that people lose money... starting with the banks that made the unwise investments, but also anyone that bought into these investments (often indirectly through pension funds).
Ok, so that bit is unavoidable, it's bad luck but it's life. Sometimes an investment doesn't work out.
But when it is a massive event like the sub-prime problem, another, far bigger problem can occur. Because of the nature of derivatives markets it was practically impossible for anyone to quickly establish their exposure, so you don't know how much money you might need, so you keep hold of your excess, but then that means that the banks that are short of cash have noone to borrow from, even though they may have enough assets to cover the debt, they need cash, which causes a problem, and then a panic, and the problem gets worse, and next thing you know you have meltdown.
So to avoid this problem the ECB temporarily created extra money, which gave the banks that needed it enough liquidity that they could deal with things whilst establishing what their situation actually was and restructuring their finances.
It's like if you had a debt collector arrive at your door in the morning demanding 2 grand or he'd break your kneecaps. If you don't have the cash and he won't take anything else then you're going to be crippled... but if I've got the cash available then I could lend it to you (with your car as collateral), you could then take your car to the dealer the same day, sell it, and repay me the next morning. The debt collector gets his money and you keep your kneecaps, all thanks to me giving you a loan to increase your liquidity at that point in time.