Originally created 09/24/01

Federal Reserve moves swiftly, without fanfare



In one of last week's little-known dramas, the Federal Reserve intervened to prevent what could have been a dangerous breakdown of the U.S. financial system, according to bankers and industry experts.

The Fed flooded banks with emergency loans in response to widespread disruptions in the systems that financial institutions use to pay each other for transactions, including short-term credits and securities purchases.

After terrorists destroyed the World Trade Center near Wall Street on Sept. 11, several of the firms that act as middlemen in financial transactions were temporarily knocked out or suffered on-again, off-again failures. That stopped thousands of wire and computerized payments in their tracks, creating a cash squeeze for some of the nation's largest and most solid financial institutions, industry experts said.

The Fed went to battle stations, extending $45.6 billion in emergency credit to financial institutions by Sept. 12, a hundredfold increase from the week before, according to data released by the central bank.

Those credits, known technically as discount loans, carried institutions over until a near-normal flow of payments was restored by the beginning of this week. Borrowing from the Fed is often considered a sign of weakness, but the central bank made sure that no stigma was attached to discount loans last week.

"The Fed spread a liquidity net under the financial system," said Peter Nerby, a securities industry credit analyst with Moody's Investor Service. "It's in nobody's interest to let very sound institutions have a short-term cash crunch because the trade processing system was temporarily incapacitated."

In addition, the Fed was anxious to prevent a demoralizing spike in short term interest rates that might have occurred if cash-short institutions had been forced to buy funds in the money markets.

Fed representatives declined to comment on last week's actions.

Banks and securities firms make hundreds of billions of dollars in short-term loans and securities purchases every day. In order to pay money they owe on these transactions, they have to receive funds they in turn are owed by a specified time.

Those daily transactions tie all the players in the financial system together in a tight web of interdependency. The failure of one player to receive payment can cascade through the entire system, affecting other institutions down the line. A widespread breakdown of the system can have potentially catastrophic consequences.

In many of these transactions, and almost always when sales of securities are involved, buyers and sellers depend on third parties to keep records and process payments, a function known as trade settlement.

That function is performed by a handful of giant firms, the most important of which are located in the Wall Street area. Several of them, including Bank of New York, the top player in the field, went completely or partially out of action Sept. 11, industry experts said.