Central banks labor to calm markets in Lehman storm

FRANKFURT/TOKYO (Reuters) - Central banks mobilized worldwide on Monday to reassure financial markets after Lehman Brothers filed for bankruptcy protection and news that Merrill Lynch, another Wall Street giant long seen as too big to fail, was being sold.

"We hope that we don't see a crisis which pushes the global economy to the brink of ruin," German Economy Minister Michael Glos said.

Central bankers had their work cut out. Share prices sank and demand soared for extra short-term lending which they offered in an attempt to keep going the system that oils the wheels of modern capitalism.

On the interbank market, overnight dollar borrowing costs surged almost one percentage point to their highest in nearly three months, showing that banks are hoarding cash rather than lending it on.

The central banks' response started on Sunday when the U.S. Federal Reserve announced that central banks, regulators and supervisors were in close contact internationally and were monitoring events as they unfolded.

It announced emergency measures for lending operations which effectively relax the terms on which commercial banks can borrow from the U.S. central bank.

In Europe, the European Central Bank, as well as the German, French, British and Swiss authorities all responded in turn.

The ECB held a money market operation where it allotted 30 billion euros in one-day liquidity to banks, only a third of the level demanded.

NOT ENOUGH?

Economists Jacques Cailloux and Gareth Claase at Royal Bank of Scotland said this high level of demand, similar to that seen when the credit crunch first forced the ECB into emergency mode in August 2007, showed how fragile the situation was.

"The ECB will likely take note that the financial system remains starved of cash and that it might thus be forced to step in again," they said.

The Bank of England put an extra 5 billion pounds into the financial system after receiving bids of nearly five times the amount of three-day funds available. The Swiss National Bank also provided extra liquidity to the money market.

The bank-to-bank premium paid for overnight dollar funds was fixed at 3.10625 percent, according to the British Bankers Association's latest daily fixing, up nearly a percentage point to hit its highest level since late June.

In Asia, officials at Japan's central bank confirmed that the authorities were monitoring the situation closely, and the message was the same in Europe.

Stocks fell in Asia, then in Europe and finally in the United States as markets in each region opened. Safe-haven debt soared after emergency weekend talks failed to save 158-year-old Lehman from becoming the latest victim of the credit crisis.

The U.S. dollar also rose as aversion to risk sparked some safe-haven flows, while the yen rallied broadly.

Wall Street's woes prompted talk that the U.S. Federal Open Market Committee may cut interest rates from 2.0 percent when it meets this week. Fed fund futures jumped on Monday to indicate a 60 percent probability of a cut to 1.75 percent on Tuesday.

Lehman filed for bankruptcy protection after the weekend talks produced no alternative, but the gloomy news on Wall Street's health went further than that.

Bank of America said it had agreed to buy Merrill Lynch in an all-stock deal worth $50 billion, looking for a bargain as the world's largest retail brokerage sought refuge from fears that it could be the next victim of the credit crunch.

Insurer American International Group Inc, working to shore up the capital of its holding company, has made an unprecedented approach to the Federal Reserve, seeking $40 billion in short-term financing, the New York Times reported.

Ten of the world's top banks agreed to set up a $70-billion emergency fund, with any one of them able to tap up to a third of that.

Lehman's filing for bankruptcy protection and Merrill Lynch's agreeing to sell itself to Bank of America remove two more names from the Wall Street map, just months after Bear Stearns. That means three of the top five have run into trouble in six months.

China's central bank also announced a major policy shift on Monday but made no link to events in New York. The People's Bank of China, said it was cutting the cost of bank loans for the first time since February 2002.

(Writing by Brian Love, with reporting from bureaux in Asia, North America and Europe)