ANALYSIS: The response to Europe's banking crisis raises issues over its ability to deal with the threat

WHEN CENTRAL banks start lending money to each other, things are usually grim. The last time it happened in large amounts was in October 2008. Then, the West’s financial system went into cardiac arrest following the collapse of Lehman Brothers.

It was revived in the nick of time but now is suffering the sort of chest pains that could be an indication of a second full-scale arrest in the offing.

The US central bank has lent its Swiss counterpart €200 million so the latter could lend it on to its banks. Separately, one euro area bank has tapped the European Central Bank’s (ECB’s) dollar stash to the tune of $500 million (€347.5 million). All this shows some European banks can’t borrow dollars in the normal way – on the markets – because their peer institutions fear they won’t get their money back.

Although the dollar amounts are small in the broader scheme of things, and it would be wrong to exaggerate the importance of these developments, they are but one of a number of signs which show the West’s financial crisis is getting worse, not better.

Another indicator of the seriousness of recent problem is the big sell-off of bank stocks in the US and Europe. On both sides of the Atlantic, financial shares are at their lowest levels since early 2009 as fears grow over another recession and the size of banks’ exposure to peripheral European sovereign debt.

But things are worse in Europe than in America. By one measure – the cost of insuring senior bank bonds in 25 leading European financial institutions – faith in the solidity of Europe’s banks is now even lower than in the post-Lehman period.

All of this is despite repeated rounds of stress tests on the same banks, done with a view to giving greater certainty about their solvency. Even more than the always-too-little response to the euro sovereign debt crisis, the policy response to the European banking crisis has raised enormous questions about the Continent’s capacity to deal with a threat that puts its prosperity, and perhaps even its social stability, at risk. But if there is plenty of cause for serious concern, there were also some oases of calm which can provide a modicum of weekend comfort. One has been the continued, and very remarkable, stability and strength of the euro vis-à-vis the dollar. The other has been the sovereign bond market.

Until recently, all eyes were on Italian and Spanish government debt markets. The day after the emergency meeting of EU leaders on July 21st, when the decision to restructure Greek government debt was formalised, yields on their bonds jumped. Their yields continued to soar, reaching new euro-era peaks over the following two weeks. Had that been allowed to continue, the euro area would have moved towards meltdown.

But the slide was halted. Over the weekend of August 6th and 7th, the ECB met. After many hours of argument in Frankfurt on the Sunday night, according to an account published this week by German weekly Der Spiegel, the bank’s executive board agreed to buy Italian and Spanish debt the following morning.

Bond purchases on the Monday and Tuesday, of €22 billion, had an instant and dramatic effect, bringing yields back down to sustainable levels. They have traded in a narrow band around 5 per cent ever since and have amazingly been unaffected by the flight to safety that characterised the behaviour of investors in most other asset classes.

Not only has ECB action calmed the sovereign debt crisis by hoovering up peripheral bonds, but its leaning on the Italian and Spanish governments to implement more radical reforms has probably helped too. Frankfurt now always gets its way, even when telling a G7 government what to do.

But for all the ECB’s growing omnipotence, it is a house divided. Its boss, Jean Claude Trichet, never tried to conceal the dissent among colleagues on the bank’s governing council when it came to buy more bonds. The Der Spiegel piece this week reported that, of the four dissenters, both German members of the board were opposed.

German hostility to such unorthodoxy has its origins in the 1920s, when massive monetary debasement destroyed the currency and impoverished the nation. But the lessons of the 1920s have been well learned. Now, a far greater threat to German prosperity comes not from ECB action, but from its inaction.