Shares on Wall Street yesterday recorded their biggest rise in five years after central banks pumped more than $280 billion (£140 billion) of liquidity into global markets. The banks’ move came amid growing fears that a new wave of credit-related pain was heading for the world’s financial companies.

The Dow Jones industrial average closed up 416.70 points, or almost 4 per cent, at 12,156.80 after the US Federal Reserve offered up to $200 billion worth of Treasury bonds to the big investment banks and other investors, in return for their damaged mortgage-backed securities. This is on top of $200 billion that the Fed made available last Friday.

In the UK, the Bank of England put £10 billion in additional funds up for auction and said it would consider providing another £10 billion next month. The European Central Bank announced plans to auction up to $15 billion, while the Bank of Canada and the Swiss National Bank said that they would run new cash auctions worth a combined $10 billion.

The FTSE 100 closed up 1 per cent at 5,969.4 points despite the liquidity injection, as investors continued to worry about the contents of today’s Budget.

Economists said yesterday’s moves indicated that credit markets were continuing to worsen. Ian Shepherdson, a senior economist at High Frequency Economics, said: “What this shows is that the arrangements the Fed had in place weren’t working. Things have got worse. They are trying to expand the liquidity-lending programme”.

Bankers said the decision by the central banks to coordinate their actions was likely to send a chill through the markets.

“It’s a very bold thing for the Fed to do . . . but if it doesn’t work, there is no plan B,” one said. “They are basically accepting busted securities as collateral for loans. I don’t ever remember central banks coordinating globally like this. That should scare the hell out of everybody.”

Adding to the gloom, Bear Stearns continued to fight off bad news. Punk Ziegel cut its target price on the American bank’s stock by half to $45 and said that Bear might be forced to look for a merger partner. On Monday the bank’s shares fell to a five-year low after speculation that it had run out of capital. Bear said there was “absolutely no truth” to the rumour.

The Fed hopes that by swapping mortgage-backed securities with bonds, banks would be better able to borrow from each other, because counterparties would be happy to accept Treasury bonds as collateral.

Interbank lending had plummeted amid a panic about the quality of the securities being used as collateral.

The credit crunch plunged to new depths last Friday as lending markets dried up amid fears that another financial institution was close to collapse. Investment banks had begun making margin calls on their hedge fund clients causing one – Peloton, a London manager – to close last week and shares in Carlyle’s CCC fund to be suspended. Last night Citigroup said it had launched a $1 billion bailout of six internal hedge funds. The bank has already injected $600 million and pledged $400 million more.

Questions of confidence

Where does this extra liquidity come from?
No money has actually changed hands. When the Fed offers $200bn of extra liquidity it is not pouring US taxpayers cash into the US banks. It is allowing banks to swap their damaged assets – mortgage backed securities – for newly issued government bonds. The Fed will hold the assets until the bonds are paid back.

How much extra cash has the Bank of England offered UK banks?
The Bank first auctioned £10bn in extra money in December and held a second auction in January. Most of that was sold as loans to banks with a three-month maturity. Now that the December loans are coming due, the Bank will recycle the cash that is paid back in a new auction. This rolling £1 0bn injection is on top of the normal cash that the Bank lends each month. How much the Bank lends is decided by 40 banks known as reserve scheme members. Between August and December last year the members asked for about 37% more each month than normal.

What might have happened if the Bank had not offered extra cash?
Most UK banks are international companies that could, and have, borrowed from America’s Federal Reserve and the European Central Bank. Because of this, there was no real concern that UK banks would run out of money. But banks need to feel secure that their central bank is ready to react quickly to changes in global financial markets. The Bank’s move is more about bolstering confidence about lending to each other than about providing funding necessary to survival.

How will this help UK banks?
As well as the extra cash available, the Bank has also said that it will accept a wider range of collateral. That means banks can use some less attractive assets as collateral.

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