KEY POINTS:
The Reserve Bank has stepped in to relieve a liquidity crunch that threatened to send the cost of business borrowing through the roof.
The unusual move followed a sharp rise in short-term interest rates in the bank bill market over the past week as the risk aversion sweeping international credit markets spread to New Zealand banks, which struggled to get overseas funding. New Zealand banks are reviewing their own credit risks, which could cause difficulties for less credit-worthy business borrowers.
The Reserve Bank under Governor Alan Bollard had warned last Thursday that it was monitoring the situation and stood ready to provide additional liquidity should that be necessary.
By Wednesday yields on 90-day bank bills had risen to 9.18 per cent, nearly a full percentage point above the official cash rate and 62 basis points higher than at the start of the month.
This reflected an increasing unwillingness of banks to lend even to each other for short periods. And it was a chilling signal for commercial borrowers, as the 90-day bank bill rate tends to be the benchmark for business lending.
At the same time, demand for Government securities - a back-up but more expensive source of liquidity the banks can use - rose sharply.
A Treasury bill tender on Tuesday, though larger than normal, was six times over-subscribed.
The Financial Markets Association, essentially a club of the large commercial banks, met on Monday to discuss the issue and convey its concerns to the Reserve Bank.
Yesterday, the bank responded by announcing that as a temporary measure it would now accept New Zealand bank bills - IOUs issued by the banks - as collateral in its overnight reverse repurchase facility.
Previously only Government securities could be used as collateral when the banks used the facility to borrow from the Reserve Bank the funds they needed to settle accounts with each other.
In effect it took the "counterparty risk" out.
This extra credit will not come cheap, however. The Reserve Bank will charge a margin of 100 basis points above the official cash rate, which it raised last month to 8.25 per cent.
Short-term interest rates fell on the news; 90-day bank bill yields dropped back nearly 40 basis points to 8.80 per cent, a high but more normal spread of 40 basis points above the interbank overnight cash rate.
"It has normalised the market really. So it has been successful," Financial Markets Association chief executive Paul Atmore said.
The problem arose because the banks themselves are finding it harder to tap one of their traditional sources of funding, the commercial paper market in Wall Street, where the appetite for foreign financial paper has been fading fast.
Amid the prevailing risk aversion and tightening credit conditions globally, New Zealand banks are reviewing their own credit risks, including untapped lines of credit they have extended.
The Reserve Bank is only the latest in a series of central banks to have moved in different ways to restore liquidity to their banking systems.
The focus is now turning to whether they will go further and ease monetary policy, to limit the impact on the real economy from the market turmoil.
Who should care?
* Business borrowers. The liquidity crunch shows New Zealand banks are not immune to the global trend to reappraise the risks of lending.
* People with floating-rate mortgages. They are priced off 90-day bank bills. The spike in 90-day interest rates did not last long enough for banks to adjust their floating mortgage rates, but if they rise to those levels again it could be a different story.
* Finance companies and people who rely on them for consumer credit. When credit is tight banks look after their best customers first. Stand-by lines of credit to rival lenders are unlikely to fall into that category.
Signs of stress
* The spread between the overnight interbank cash rate and 90-day bank bills widened rapidly to hit 78 basis points by Wednesday - an extremely wide gap by historical standards.
* Demand for Government paper that can be sold to the Reserve Bank for cash rose to abnormally high levels, even though that is an expensive form of liquidity for the banks.
* Senior commercial bank executives met on Monday to discuss the crisis. They came up with no plan of action but conveyed their concerns to the Reserve Bank.
* The Reserve Bank had said last week that it was ready to provide additional liquidity to the banking system if need be. Yesterday it decided it was needed.
