The unprecedented action by five central banks in response to the credit crunch is only a short-term solution to the problem.

The co-ordinated action by five of the world’s largest central banks on December 12 last year to inject liquidity into ailing global financial markets marks a significant turning-point in central banking and raises the critical issue of what central banks can do in response to financial crises.

In the past, quiet meetings in secluded Basel did the trick. Today the game has changed and central banks in many countries are no longer the regulators of the banks – as was seen poignantly in the UK in the recent Northern Rock debacle. Central banks have been de-toothed as their supervisory roles have been separated away.

Capabilities questioned

In addition, globalisation and the growing complexity of financial instruments as well as new players from hedge funds to private equity and sovereign wealth funds, have led to increased questioning of the capabilities of both central banks and regulators to understand and supervise their markets. Along with this, the current subprime crisis has highlighted concerns about the rating agencies.

Easing the squeeze

What can be done? Well, in the December 12 meeting, the central bank heavyweights – the US Federal Reserve, European Central Bank, Bank of England, Bank of Canada and Swiss National Bank – decided to tear up their rule books and established practices and join forces to inject cash, resuscitate the interbank market and hopefully ease the credit squeeze.

The five recognised they needed to act together to solve this global crisis of confidence of the banks. But will it work? Clearly it provides a solution to the stigma attached to previous financing models that have failed; the use of new facilities is anonymous. But further cash injections may be needed to get interbank lending flowing. Getting over this crisis in the short term may be possible but what about the long-term future of central banks?

This latest process may be a solution for now and co-ordinated action is definitely the way to go, but the strategy also emphasises the impotence of the central banks. Cutting interest rates no longer has the desired impact and injections of liquidity may not work either. For a more complex financial world, central banks require a more comprehensive tool-kit. Dramatic changes and better tools are desperately needed.

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