By Joellen Perry

6 November 2007

The Wall Street Journal

FRANKFURT -- At 12:32 p.m. on Thursday, Aug. 9, just past its ninth birthday, the European Central Bank grew up.

The summer's mounting financial crisis, sparked by rising defaults on U.S. subprime mortgages, had fully crossed the Atlantic that morning. European banks feared their counterparts were exposed to risky investments linked to these mortgages, and became unusually reluctant to lend to each other. Financial institutions were paralyzed.

Tasked with stopping such a meltdown was the European Central Bank, which sets monetary policy for 13 countries from Ireland to Greece. The institution has been dogged since inception by criticisms that it valued consensus over decisiveness. Early on, it had been called slow-footed, disorganized and prone to miscommunicating its intentions.

But that day, the ECB swooped to the rescue. The bank offered unlimited overnight loans at its policy rate of 4%. By day's end, it had lent €94.8 billion -- about $131 billion -- which was more than it had put into money markets the day after Sept. 11, 2001. The first response by a major central bank to the summer's crisis, it stunned markets for its size. It also surprised counterparts at the U.S. Federal Reserve, who followed the ECB's injection with a smaller $24 billion one of their own later that day.

Observers credit the ECB and its head, Jean-Claude Trichet, with making a trenchant decision that calmed markets. The move shored up confidence in the bank's ability to keep markets functioning for the U.S. dollar's most significant rival. With its boosted credibility, the ECB could enhance the euro's standing in world markets. Continued confidence in the currency could ultimately come at the expense of the dollar, the current favorite of big world investors thanks in part to the size, liquidity and stability of U.S. markets.

"There were always worries that the ECB would be a stereotypical European institution, slow to decide and going off in multiple directions at once," says Adam Posen of the Peterson Institute for International Economics, a Washington think tank. "Mr. Trichet has put that to rest in this situation."

The ECB now faces fresh challenges. Global stock markets are swooning as the credit-market fallout deepens, with big write-downs and CEO departures at Citigroup Inc. and Merrill Lynch &Co. spurring fears that other banks could post more big losses. European bank shares fell yesterday, helping to bring down major indexes. And, as in the U.S. and United Kingdom, the gap between the rates euro-zone institutions charge each other for longer-term loans and the ECB's target rate remains unusually wide, suggesting markets remain tense.

This complicates the picture for ECB policy makers, who meet Thursday. Prior to the summer's credit-market unrest, robust euro-zone growth had the bank set for at least one more interest-rate rise this year. Now policy makers are caught between worries that inflation pressures are building, while the economy has yet to feel the full effect of credit-market turmoil, bank-sector write-offs and the euro's surge. In contrast to the Fed, which has cut rates by 3/4 of a percentage point since September, the ECB is likely to keep its key rate on hold Thursday. Investors see a protracted pause, but some policy makers have said the rate still could rise.

A portrait of the ECB's August response to the financial crisis emerges from documents, public statements and people familiar with the bank's workings. The ECB had been primed for a liquidity lockup, running Pentagon-style war games with such scenarios as early as April 2005. Its president, long-time French central banker Mr. Trichet, had warned loudly that investors were underestimating the danger of risky holdings. After market tremors earlier in the summer, ECB staffers who monitor markets were on high alert.

Some observers criticized the ECB for inciting panic with its intervention, saying the scope of its response suggested the bank was bracing for a catastrophe. A few still say the ECB overreacted, arguing that the offer of unlimited funds at the ECB's target rate -- the central-bank equivalent of a fire sale -- rewarded the type of risky investments that spurred the subprime debacle to start with.

The ECB still has vulnerabilities, of course, as separate events over the past three months have demonstrated. A communication gaffe by the bank left financial markets confused for days in mid-August about whether the ECB intended to raise rates. A fragmented system of bank supervision left it without detailed information about bank balance sheets at a moment of crisis. And it faces persistent sniping from politicians as it refuses to restrain a rise in the euro on foreign-exchange markets that is provoking yelps from some exporters.

The ECB was established on June 1, 1998. Critics derided the institution as unworkable from the start. To shore up credibility, the ECB modeled itself after Germany's inflation-phobic Bundesbank. Like the U.S. Federal Reserve, the ECB sets a target for interest rates on overnight loans between banks. But unlike the Fed, whose dual mandate makes it attentive to both inflation and growth, the ECB's prime focus is on keeping prices stable. It aims to keep inflation at just under 2% in the 13 countries that now share the euro currency.

The ECB's rate-setting body includes the six members of its Executive Board, who oversee the bank's day-to-day operations, plus the 13 heads of the euro-zone's national central banks. Rather than voting on interest-rate decisions and publishing the minutes of their meetings, as Fed officials do, the ECB's 19 Governing Council members make decisions by consensus. The bank explains its thinking in a news conference after each decision.

The euro debuted with fanfare, and an initial value of $1.17, in 1999. Although the ECB's primary focus is inflation, not the exchange rate, a falling currency can be read as a market vote of no-confidence in an economy and its managers. Over the next 22 months, amid scattershot communication from ECB policy makers, the euro deteriorated to 83 cents.

The bank's now-deceased first president, Wim Duisenberg, initially reinforced the perception of disorganization. Although he had been an accomplished former Dutch central-bank head, the lanky policy maker with a mop of white hair became known at the ECB for a colloquial candor, uncommon in central-banking circles, that repeatedly steered markets the wrong way. British tabloids dubbed him "Dim Wim."

Since late 2003, the ECB's public face has been Mr. Trichet. A poetry buff who studied economics and mining engineering, the 64-year-old Mr. Trichet is long on practical experience, from the French Treasury to the World Bank. He was president of the Paris Club of creditor nations from 1985 to 1993, an era in which Latin American, African and Russian debts were restructured, and head of the French central bank for a decade.

By 2005, the ECB was preparing for potential market chaos. That April, at its 37-story glass-and-metal headquarters in Frankfurt, 65 participants spent two and half days in exercises aimed at honing their response to a future crisis. About a year later, some 150 people took part in a conference from their home countries to play out shocks to the financial system. In 40 teleconference calls over half a week, the group responded to various scenarios, including a prescient case in which banks sought emergency loans but policy makers didn't know whether the banks were solvent. Top policy makers were barraged by rumors, sometimes contradictory, and by actors playing inquisitive journalists.

The real thing arrived this summer. For months, U.S. homeowners with subprime mortgages -- high-interest loans extended to high-risk borrowers -- had been defaulting in rising numbers. Investors who had bought opaque securities backed by these mortgages ran into trouble as the securities became difficult to value and thus potentially hard to trade.

By late July, there were mounting clues that continental European banks were vulnerable. On July 27, the little-known German IKB Deutsche Industriebank AG revealed it had major exposure to the U.S. subprime-mortgage market, prompting an emergency weekend 3.5 billion euro bailout organized by Germany's financial regulator, with contributions from major German banks.

Markets lurched into early August. Even as European business slowed for vacation, the ECB's team of market monitors -- usually about 15 people, whittled to around a dozen because of vacations -- was on alert. Working on the second floor of the bank's high-rise, the team watches everything from global stock-exchange movements to copper prices.

Some five members of the team monitor money-market rates, the interest banks charge each other for loans. In the afternoon of Tuesday, Aug. 7, rates on loans ranging from overnight to a year started rising. This was puzzling: Just that morning, the ECB had conducted its regular weekly refinancing operations. That should have provided banks with enough cash to last them the week -- and, by extension, kept the rates between banks relatively flat.

In phone calls with the market monitors, commercial bank treasurers confirmed their banks were antsy.

Wednesday brought more jitters. Though the ECB had set its target rate at 4%, overnight money-market rates continued rising above that. Investors were fleeing to havens such as two-year German government bonds. Data showed commercial banks' reserves with the central bank had fallen, another sign that banks might be hoarding cash.

By Wednesday evening, staffers had suggested that the six-member Executive Board consider taking the unusual step of injecting cash to restore calm. By then, Mr. Trichet and Lucas Papademos, the ECB's vice president, were in touch with U.S. Fed governors.

The ECB prefers to stage major interventions before noon, when commercial-bank treasurers are sure to be at their desks. The bank decided to wait until the morning and act if markets were still tense.

They were. At 8:30 a.m. on Thursday, Aug. 9, major French bank BNP Paribas announced it was suspending withdrawals from three investment funds because it couldn't value them amid the subprime crisis. Rumors flew that other banks were in trouble.

"I've never experienced anything like it," says Christoph Rieger, interest-rate strategist at Dresdner Kleinwort in Frankfurt. The fear "ground the market to a halt."

Interest rates on overnight loans between European banks soared. Typically, market monitors snap to attention if the overnight rate moves a few hundredths of a point away from the bank's policy rate. Now, rates hit 4.7%, far above the ECB's 4% target, signaling extraordinary tension.

Convening at 8:45 a.m., the ECB liquidity group decided to recommend intervening that morning and taking the unprecedented step of pre-announcing that the bank would honor every bid it received. To send a clear signal that the bank was covering the market's back, the committee settled on offering funds at the bank's 4% policy rate rather than a variable rate or a higher penalty rate. Taken together, the moves would show the ECB just how high the demand for cash was, because banks, in principle, would bid for exactly what they felt they needed. The ECB could use the information to judge future injections more accurately.

The six Executive Board members approved the move within 90 minutes.

At 10:26 a.m., the bank told markets it stood "ready to act." At 12:32 p.m., it flashed its decision on trading screens across the euro zone. The notice said the ECB would accept bids for funds until 1:05 p.m. Response was immediate. At 2 p.m., the ECB publicized the total take of 94.8 billion euros. The overnight rate fell back down to around 4%. In subsequent days and weeks, the ECB continued to add funds to money markets to keep the market liquid.

But challenges continued to arise, in part because the ECB doesn't have detailed insight into the euro zone's banks. While the Fed effectively supervises most of the biggest U.S. banks and has access to detailed information on these banks' books, the ECB cedes banking supervision to each member country.

Days after its Aug. 9 fund injection, the central bank sent commercial-bank supervisors across the euro zone a questionnaire asking about their subprime exposure. The basic question: Were banks basically sound and just having a problem with short-term liquidity? Or were some of them in deeper trouble?

Some responses were returned quickly and fully. Others came back late or without sufficient numbers. In the end, the ECB learned enough to be confident that banks were sound. But some people in and out of the ECB are unsure that the bank would get the information it needs in a bigger crisis.

In the following weeks, another old ECB problem resurfaced -- communicating intentions clearly to the market. Mr. Trichet had been getting high marks for predictability, but that changed on Aug. 22.

On the back of the ECB's continuing cash injections, overnight lending rates had fallen back to around the 4% target. But three-month interbank rates still hovered around 4.7%, a sign that banks were reluctant to lend to each other for longer periods.

At 3:34 p.m. that day, the ECB released a surprise statement saying it would hold an auction the following day, accepting bids for 40 billion euros in extra three-month funds. Markets greeted the announcement with relief. But the statement's last sentence caused confusion. "The position of the Governing Council of the ECB on its monetary policy stance was expressed by its president on 2 August 2007," it read.

That was a reference to a briefing held by Mr. Trichet weeks earlier, at which he indicated that the bank, at the time, was inclined to raise short-term rates at its next meeting on Sept. 6. In the intervening turmoil, however, markets had steadily revised down expectations of an ECB interest-rate rise. The late August statement seemed to put a hike back in play.

"To say markets didn't know how to interpret it is putting it mildly," says Dresdner Kleinwort's Mr. Rieger.

The communication problem was compounded two days later, on Aug. 24. Anonymous sources at several national central banks leaked word to Reuters that markets had misinterpreted the sentence about the ECB's monetary-policy intentions: ECB policy makers were not set on raising rates. Speaking in Budapest a few days later, Mr. Trichet intervened to clarify the message, essentially telling markets that policy makers hadn't decided whether to move rates.

On Sept. 6, the bank kept its policy rate unchanged at 4%.

Observers say that while the bank proved its chops with its early August moves, it still has room to master the subtle art of communicating its intent. "It's as important as moving rates well," says Luigi Buttiglione, a former Bank of Italy economist, now with New York-based investment fund Fortress Investment Group in London, who praised the August intervention. "You not only have to do the right thing, but you have to explain why this is the right thing. If you're not able to do that, then markets can take a different direction -- and you can achieve the opposite result."