Central banks strain to contain market crisis

A man looks at an electronic board displaying a graph of Japan's Nikkei share average in Tokyo September 16, 2008.

WASHINGTON/BERLIN/TOKYO (Reuters) - Central banks pumped emergency funds into world financial markets for a second day on Tuesday in an increasingly fraught effort to contain the fallout from the crisis sweeping Wall Street's biggest firms.

The injection of hundreds of billions of dollars into money markets to stop them freezing up failed to prevent a surge in the cost of borrowing between banks, in some cases on a scale unseen even when the global credit crunch hit in August 2007.

Stocks extended their slide, with Europe's FTSEurofirst index hitting a three-year low at one stage as investors fretted over events on Wall Street, where Lehman Brothers, once thought too big to fail, filed for bankruptcy protection on Monday, and where another giant, insurer AIG, is seeking survival help.

"It's clear that this financial market crisis is the worst worldwide in decades -- and it is not over," Germany's finance minister, Peer Steinbrueck, told parliament.

The Federal Reserve pumped in $50 billion into the markets on Tuesday, following up on the $70 billion it provided on Monday, and said it was ready to do more.

There was even market speculation that the Fed could reduce interest rates by as much as a half percentage point at a meeting it was holding on Tuesday.

The European Central Bank injected 70 billion euros ($98.09 billion) into money on Tuesday, after 30 billion the day before. Demand from banks for Tuesday's funds, a measure of how much other sources of liquidity are drying up, topped 100 billion.

In Britain, the Bank of England injected 20 billion pounds ($35.21 billion), after five billion on Monday. Demand was three times the amount of extra liquidity offered on Tuesday.

WHEELS SLOWING

The cost of borrowing dollars overnight, as revealed by the LIBOR (London interbank offered rate) fixing, more than doubled to 6.43750 percent from 3.10625 on Monday, its highest since January 2001, the latest fixing by the British Banker's Association on Tuesday showed.

"This is much worse than August last year," said one market source, referring to the day the credit crunch snowballed out of the United States, forcing central banks to launch emergency liquidity operations.

Asian central banks also rolled into action, with those of Japan, Australia and India flooding money markets with cash. The region's banks doled out $17 billion, following Monday's $70 billion Federal Reserve injection.

The Bank of Japan made its biggest cash injection in almost six months -- 1.5 trillion yen ($14.2 billion) -- and the prime minister met top financial policy makers to discuss events.

The rates at which banks lend to each other jumped in South Korea too, and in the financial hub of Hong Kong, while Asian stock markets, many of them closed for a holiday on Monday, tumbled and currencies whipsawed.

FED CUT?

The Bank of Japan is expected to leave its key interest rate unchanged at 0.5 percent on Wednesday.

In contrast, markets were pricing in an almost 100 percent chance of a quarter-point cut in the U.S. benchmark rate, to 1.75 percent at a Fed meeting on Tuesday. And U.S. short-term interest rate futures showed about a one-in-three chance that the Fed would cut by half a percentage point, to 1.5 percent.

"The U.S. central bank is facing a state of crisis in the financial markets from a perspective of solvency, liquidity and confidence," said Ashraf Laidi, chief FX strategist at CMC Markets US in New York.

U.S. markets appeared poised for another selloff on Tuesday after ratings agencies downgraded AIG's debt, complicating its battle for survival.

Shockwaves from the Wall Street crisis prompted the Reserve Bank of Australia to pump nearly A$1.8 billion ($1.5 billion) into the banking system in its second injection in two days.

The Reserve Bank of India added almost 60 billion rupees ($1.32 billion) through a refinance operation, its biggest injection in at least a month.

Hong Kong, South Korea, Taiwan, New Zealand and Indonesia all offered verbal reassurances, as did governments in Europe.

Russia's central bank injected a record $14 billion on one-day funds while in Norway the central bank allotted $5 billion in one-week foreign exchange swaps, having earlier in the day suspended a new fixing for daily money market rates due to lack of liquidity..

Paris, Berlin and Rome have all made statements saying banks on their own patches should see only limited damage from events on the other side of the Atlantic.

Germany's Steinbrueck said one risk outside the financial sector was the extent to which banks would stop lending to firms and individuals, hitting the economy more generally.

Eric Woerth, France's budget minister, said he believed the crisis remained primarily one for investors and the financial sector but not retail bank depositors, even if they too could suffer from banks being less willing to lend.

(Writing by Brian Love, with reporting by correspondents in Asia, Europe and North America, editing by Swaha Pattanaik)