Bankers across the country, concerned about the impact of war in the Persian Gulf on their institutions, are counting on the Federal Reserve to provide essentially an unlimited supply of cash for the banking system now that the shooting has started.
The Fed has made no announcement about its intentions, but the central bank's traditional response to any sort of serious market upheaval has been to do just what the bankers expect -- flood the system with money until things calm down again. The goal will be to assure bankers and borrowers that any extraordinary demand for money will be met.
This morning, only hours after hostilities began and as markets open in the United States, officials at the Fed's System Open Market Desk located at the Federal Reserve Bank of New York will assess the need for funds at two levels:
One, they will closely watch objective indicators such as the federal funds rate and, second, they will make a more subjective judgment by calling dozens of money managers, traders and other executives at banks, government securities dealers and brokerage houses.
The Fed officials will also have in hand an estimate of the entire banking system's need for funds based on their assessment of other factors, such as projected levels of deposits at banks.
With that information, Open Market Desk officials in New York and others at the Federal Reserve Board in Washington, perhaps including Fed Chairman Alan Greenspan, decide each day whether to add or subtract cash from the system.
On a normal day, the Fed would simply provide enough funds to keep the federal funds rate -- the interest rate institutions pay each other for money lent overnight -- generally close to its target, currently 6.75 percent.
But this morning, such fine considerations could go by the boards, particularly if the opening of war with Iraq causes any large disruption in financial markets. Even if there is no marked disruption, the Fed might choose to inject a large amount of funds simply to demonstrate its willingness to do so, one analyst said.
Some large banks that depend on borrowed money in addition to deposits as a source of funds for their operations already have taken steps as best they could to insulate themselves from any financial market gyrations, such as a sharp increase in the interest rates they have to pay for such borrowed funds.
First Interstate Bank in Los Angeles, the nation's 10th-largest commercial bank, for example, has built up a large cash cushion so that it can avoid borrowing as much in the market as it normally would.
In Philadelphia, Terrence Larsen, chairman of CoreStates Financial Corp., said that at a meeting of his bank's management committee, "98 percent of what we talked about was our own funding. There is a tendency for people to go to cash in this kind of situation, so we have to have the liquidity to do that."
Since most banks face the same circumstances, the entire system will need more funds. "That could mean the Fed will have to supply liquidity, but I am sure they have thought of that," Larsen said.
Greenspan said earlier this week that problems with banks' funding themselves in December created "an extraordinary credit crunch ... which we at the Federal Reserve reacted to by literally flooding the market with reserves."
Such a flood of cash pouring into the banking system prevented "the seizing up of the market at year-end," Greenspan declared.
The Fed moved in similarly aggressive fashion in the wake of the October 1987 stock market crash and has done so on other occasions to calm markets following an unsettling event. The major difference this time is that the event came as no surprise.
The actual provision of money occurs as the Fed buys U.S. government securities from a group of major securities dealers. The Fed credits the bank accounts of the dealers with cash, which puts more liquidity into the system. Often such deals are only temporary, with an agreement that the dealers will repurchase the securities after a day or two.
If the Fed wants to drain cash from the banks, the deals go the other way, with the Fed selling securities from its portfolio to the dealers. As the dealers pay for them, cash flows from the banks into the Fed.
Larsen said the fragility of many financial institutions and the public's uneasiness about the banking system makes it particularly important there be no question about the banks' ability to fund themselves and to respond to the public's need for cash.