Jean-Claude's volte-face

There couldn't be a more pertinent message for our time: it's liquidity, stupid. Banks would do well to take heed as fixed assets become devalued and, once again, cash is king

It’s liquidity, stupid. Within days of the European Central Bank unveiling tougher wholesale lending rules applying from next February, the collapse of Lehman Brothers served as a sharp reminder to governor Jean-Claude Trichet that we’re still a long way from the bottom. And so in a rapid turnaround, the ECB quickly made available 70bn euros [$100bn] to lubricate the markets. It’s a fair bet that in these parlous circumstances the central bank did not enquire too closely about the merit of some of that paper passing through its repo window.

As the crisis continues to deepen beyond all expectations, liquidity rules. Until the global financial markets run freely again, whenever that may be, the ECB should temporarily jettison any anxieties about its window being used to unload B-grade or even C-grade collateral and keep pumping out the credit. Why hike the cost of raising critically needed funds against asset-backed paper at a time like this? While it’s very likely, as one member of the ECB governing council put it, that some banks are “gaming the system”, this is hardly the moment for delicate considerations of moral hazard. Retribution can come later.

And perhaps the ECB might refrain from statements that further threaten a financial sector already reeling on the ropes. In early September, Mr. Trichet announced deeper haircuts for the more dubious asset-backed paper. Although he was at pains to stress that the discounts affected only a small percentage of this collateral, these are not normal times. Next day, bank stocks took a dive as nervous investors assumed the ECB knew more than they did about the amount of B-grade debt out there and was battening down the hatches for the long haul.

In this hyper-sensitive market, central bankers should do nothing to rock an highly unstable boat. The governor nearly went from hero -- the central banker who first spotted the gravity of the credit crunch and opened the taps -- to zero as the central banker who worsened it.

Nobody is suggesting the ECB or other central banks should load their vaults with a ragbag of overpriced packages of debt. Accurate valuations must be the order of the day, if only to reward those institutions that loaned wisely during the credit spree and come to the ECB’s window with high-quality collateral. But in view of the enormous amount of capital that the world’s banks must raise over the next year or so to shore up their balance sheets as well as to pay for their sins, liquidity has got to be the main preoccupation.

According to Mario Draghi, governor of the Bank of Italy and head of the Financial Stability Forum, banks need to cobble together about 246bn euros [$350bn]. Although the EU’s banks are less vulnerable than their US counterparts, Mr. Draghi reckons they account for about a third of total write-downs of 352bn euro [$500bn] and have some serious repair work to do.

Ominously, there’s also a growing fear about “hidden leverage” in both financials and non-financials. As the entire industry knows by now, the bankrupt Lehman was a big lender to hedge funds that may now find this debt difficult to replace. Also, there may be other ramshackle edifices similar to the structured investment vehicles [SIVs] where banks hid their subprime “assets”.

Keep the window open, Mr. Trichet, but take their names.

It’s another safe bet that the ECB will be more lenient than it’s letting on when banks come, collateral in hand, to the repo window in February.