Fed to test auction for cash-strapped banks

WASHINGTON -- The Federal Reserve on Wednesday announced a novel approach to injecting money into the banking system as it struggles to combat a severe credit crunch that threatens to drag the country into a recession.

The Fed said it would conduct two auctions next week where banks can bid for up to $40 billion in loans, money they will have to bolster their own reserves. It marked the Fed's biggest concentrated effort to inject liquidity into the banking system since the Sept. 11, 2001, terrorist attacks.

The hope is the extra funds will spur increased lending on the part of the banks and combat a serious credit crunch that has made loans harder to obtain for many businesses and individuals.

The announcement initially lifted spirits on Wall Street, with the Dow Jones industrial average up as much as 272 points in early trading. However, stocks could not hold on to most of those gains as investors began to worry the Fed's new auction plan wouldn't be enough. The Dow finished the day up 41.13 points at 13,473.90.

That performance followed a huge 294-point drop in the Dow on Tuesday as investors expressed disappointment at what they viewed as a timid interest-rate cut by the Fed. The central bank trimmed its federal funds rate, the interest that banks charge each other, by a quarter-point.

The Fed linked the new auction process to an announcement it was extending a line of credit in dollars to the European Central Bank and the national bank of Switzerland so those institutions could better deal with credit problems in Europe. The Fed said it was also coordinating with the central banks of England and Canada.

"They are trying to help hard-pressed banks raise much-needed cash. The banking system is under severe pressure because the banks don't want to lend to each other," said Mark Zandi, chief economist at Moody's Economy.com.

The Fed's new program will begin with two auctions next week and another two in January. The first auction for up to $20 billion will occur on Dec. 17, followed by a Dec. 20 auction for another $20 billion.

The Fed is trying the auction program as an experiment to provide another avenue for providing loans to banks. Banks have shied away from borrowing from the Fed's discount window because of the stigma that can be linked to doing so.