Overnight on August 9/10 and during the morning of August 10, Australia experienced a very sharp credit shock, not as bad as Europe had seen the night before, or the US, but a shock nevertheless. Here’s what RBA deputy governor Ric Battelino told a Sydney conference today in a speech.

The problems experienced in money markets in recent weeks had their origins in the credit and market-related losses incurred by investors who had bought securities collaterised by US sub‑prime mortgages. Various investment funds worldwide, including in Australia, have been reporting losses on these securities for some months now.

Most of these have been hedge funds, and while the losses incurred in some cases have been severe, these problems for quite some time did not seem to have any significant ramifications more generally through the financial system.

That changed on 9 August, after a large European bank announced that it was freezing withdrawals from three of its investment funds due to losses incurred by those funds and the difficulty in valuing their security holdings. This seemed to trigger a shift to a much more risk‑averse approach by money market participants in dealing with each other.

What seemed to be worrying people was that, while the US Fed had calculated the losses in the sub‑prime market as being potentially as high as US$100 billion, only a few billion of losses had been announced by investment funds.

This naturally led market participants to question who was sitting on the prospective losses, and what this meant for the creditworthiness of market counterparties.

Investors became much more risk‑averse and banks severely curtailed their lending to each other, causing gridlock in the money market.

The process spread quickly because once banks started to worry that others may stop lending to them, they in turn stopped lending to others.

Central banks responded to this by sharply increasing the amount of funds supplied to their banks in the money market. Among the developed economies, the European Central Bank, the US Fed, the Bank of Japan, the Bank of Canada, the Swiss National Bank, the Norges Bank, the Reserve Bank of New Zealand, as well as ourselves here in Australia, all did so to varying degrees.

Some also took other measures. The Fed, for example, cut the penalty rate on its discount window from 100 points to 50 points in order to lessen the cost of emergency funding to banks. Some central banks also widened the range of securities in which they were prepared to deal.

Despite the fact that Australian banks are in very sound condition and have been experiencing minimal credit losses, they were nonetheless affected by the spread of the global money market turmoil.

On the morning of 10 August, banks started telling us that they were noticing a reduced flow of funds through the market.

The cost of raising funds in global markets through swaps had risen noticeably, putting more pressure on domestic funding sources. Yields on banks bills had jumped sharply overnight, and LIBOR rates by even more

The Reserve Bank decided to supply more than the usual $700‑800 million of exchange settlement funds, so that the overnight interest rate would not rise above the target set by the Board in early August.

Those operations were successful in maintaining the cash rate at the 6.5 per cent target, though other short‑term market interest rates remained unusually elevated.

Since then, the Bank has continued to supply whatever amounts of exchange settlement balances were necessary to keep the cash rate at the target. In the process, balances rose to a peak of $5.5 billion in the middle of last week, the highest level for some years, though some of this has been reversed recently.

The Bank also skewed its market operations more towards bank bills, rather than government securities, to enhance confidence in the liquidity of highly‑rated instruments in the bill market.

The proportion of the Bank’s operations undertaken in bank bills has risen to around 80 per cent, well above the usual 30 per cent share. T

This has lifted the Bank’s domestic bill repo book from a little over $18 billion at the start of August to around $40 billion today. The term of repos has also been lengthened appreciably, from the usual average of around 20 days to over 100 days, to provide greater certainty of funding.

These operations have held the cash rate at the target, and helped to stabilise market conditions more generally. Nonetheless, some pressures remain. Yields in the bill market remain somewhat higher than usual relative to the cash rate, and yields on asset‑backed commercial paper even more so.

The volume of securities issued has fallen, and the maturities have shortened. Banks have switched some of the funding of their conduits from the asset‑backed commercial paper to on‑balance‑sheet, where it is supported by the banks’ capital. This seems appropriate.

In recent days, there have been some encouraging signs of improvement in markets, both here in Australia and overseas. The Bank will continue to monitor the situation carefully. If market developments warrant, the Bank has scope to further expand the provision of liquidity. These matters are being kept under review.”