The recent developments were triggered by a perception of higher credit risk originating from a perceived deterioration of the credit quality of assets held both by banks and by special  BIS Review 130/2007  3  investment vehicles, with which banks were associated either through liquidity commitments or reputation issues. The situation deteriorated when liquidity buffers of banks were put under stress by the need to meet their liquidity commitments and to take on their balance sheet assets which had become illiquid. Then, banks also became unwilling to provide unsecured lending to other banks, in particular at longer maturities, because of uncertainty whether they would themselves obtain liquidity if needed. Once this stage was reached, the deterioration of liquidity conditions became self-reinforcing, and turned out to be painfully durable, as can be seen for instance from the still exceptional three-month EURIBOR spread relative to three-month repo rates. What could central banks do about this? First, they provided extra liquidity through open market operations. This not only contributed to bringing down short-term interbank rates to target levels again, fulfilling monetary policy implementation purposes, but may also have contributed to supporting the willingness of banks to lend. Second, accepting that availability of central bank eligible collateral is the ultimate line of defence against illiquidity for banks, many central banks widened the set of eligible collateral. For instance, the central banks of Canada and Australia took such actions, and also the US Fed clarified that it would accept certain instruments in its discount window.
The immediate future: consolidating the measures taken and putting the reforms on a firm footing In recent weeks international financial market dynamics have continued to be influenced considerably by the high degree of risk aversion and by fragile confidence levels. There has been a resurgence of the doubts – first seen in the case of Greece – about the solvency of euro area Member States. The uncertainty over the euro area’s fiscal sustainability cannot be explained merely by the economic downturn and its impact on public finances. The measures taken by authorities to avoid the collapse of the financial system have involved, in the case of Ireland, guaranteeing the funds lent to the banking system by depositors and wholesale investors. Markets are suspicious about the ability of certain small States, with relatively large banking systems, to meet these commitments. The European Union has come to the aid of Ireland, which has experienced problems precisely because it used substantial amounts of public funds to shore up a banking system bloated with real estate assets, particularly offices and houses in the Dublin area. In Spain the situation is very different as regards both the public sector and the banking sector. Despite the substantial rise in the budget deficit in 2008 and 2009, public debt as a percentage of GDP remains relatively small in comparison with the euro area average, which is 20 percentage points higher.