What’s at stake: The ECB, Fed and other major central banks agreed last Monday to lower the pricing on the existing U.S. dollar liquidity swap arrangements and extend their authorization in order to ease strains in financial markets and thereby mitigate the effects of such strains on economic activity. This issue investigates why European banks need US dollar liquidity, how the new swap program differs from the one that was introduced in December 2007, and discuss its likely impact on the Fed’s balance sheet.
Why do European banks need dollars?
Binyamin Appelbaum writes in the Economix that the announcement surely raises the question: Why do foreign banks need dollars? The simple answer is that foreign banks really like the things that dollars can buy. They liked investing in American government debt, and lending money to American corporations, and most of all they liked buying American mortgages and all manner of crazy investments derived from those mortgages.
According to a 2009 BIS report, bank holdings of assets denominated in foreign currencies ballooned from $11 trillion in 2000 to $31 trillion by mid-2007. European banks posted the fastest growth, and that growth was concentrated in dollar-denominated assets. By the eve of the crisis, the dollar exposure of European banks exceeded $8 trillion. Many of these investments were funded on a short-term basis. The paper from the Bank for International Settlements estimates that European banks had a constant need for $1.1 trillion to $1.3 trillion in short-term funding. The banks raised that money mostly by borrowing domestically and then acquiring dollars through foreign-currency swaps. Banks also sold short-term debt to American money-market funds.
For more on this issue, the reference is the 2011 IMF Mundell-Fleming Lecture by Hyun Song Shin (click here for the video), which outlines the role of European global banks in adding to the intermediation capacity for connecting US savers and US borrowers. According to Shin, the regulatory environment in Europe and the advent of the euro are certainly the main reasons as to why it was Europe that saw such rapid increases in banking capacity, and why European (and not US) banks expand intermediation between US borrowers and savers. The European Union was the jurisdiction that embraced the spirit of the Basel II regulations most enthusiastically, while the rapid growth of cross-border banking within the eurozone after the advent of the euro in 1999 provided fertile conditions for rapid growth of the European banking sector. In contrast, US regulators have been more ambivalent toward Basel II, and chose to maintain relatively more stringent regulations (at least, in the formal regulated banking sector) such as the cap on bank leverage.
The new swap lines
Gavyn Davies writes that central banks have become extremely alarmed about the deterioration in the funding market for eurozone banks, and the consequent deleveraging of bank balance sheets which this is causing. In recent weeks, the deterioration in the eurozone debt crisis has undermined confidence in the solvency of eurozone banks, and dollar financing for them has dried up.
Claire Jones notes that the ECB went a step further than its counterparts by lowering the margins, or haircuts, applied on the assets that borrowers hand over to the central bank in order to secure dollars. The current margin, or discount, applied would be cut from 20 per cent to 12 per cent. Recent Bank of Canada research suggests that central banks could be better off easing haircuts in times of crisis: if liquidity threatens the well-functioning of the financial system, the benefits of providing additional central bank liquidity by reducing haircuts or expanding the list of eligible assets can outweigh the potential costs associated with the distortion of asset portfolios and the higher risk exposure of the central bank’s balance sheet.
James Hamilton outlines a different feature from the swap lines introduced in late 2007: liquidity can be provided in foreign currencies if market conditions warrant. Indeed, even more dramatic as the recent increase in the TED spread, which measures the difference between the yield on 3-month interbank loans of Eurodollars and the U.S. T-bill rate, is the spreads on term interbank loans denominated in euros.
The impact on the Fed’s balance sheet
Michael Fleming and Nicholas Klagge of the NY Fed have a short paper on the Fed’s Foreign Exchange Swap Lines that were introduced at the end of 2008. The Fed greatly expanded this system of swap lines in size and scope during the fall of 2008. By December 10, 2008, swaps out- standing had risen to more than $580 billion, accounting for over 25 percent of the Fed’s total assets. During 2009, financial strains abated and demand for the swaps diminished steadily, leading to the program’s termination in early 2010. Early evidence suggests that the swap lines were successful in smoothing disruptions in overseas dollar funding markets. Swap line announcements and operations were associated with improved conditions in these markets: Although measures of dollar funding pressures remained high throughout the crisis period, they tended to moderate following large increases in dollars lent under the swap line program. Moreover, the sharp decline in swap line usage as the crisis ebbed suggests that the pricing of funds offered through swap lines gave institutions an incentive to return to private sources of funding as market conditions improved.
Gavyn Davies writes that because this dollar injection was not sterilised by the Fed, the swap lines were one of the main reasons for the explosion in the Fed’s balance sheet at the time. This programme has now been reactivated, and it could grow quickly if concerns about the solvency of eurozone banks are not resolved by next week’s summit. Therefore the Fed seems to have taken on a potentially open-ended commitment, which could involve a further large increase in QE, aimed at the eurozone banks. The impact of all this on the Fed’s balance sheet depends on whether they sterilise the swap operations by selling other assets from their balance sheet, thus draining US bank reserves at the Fed. It seems unlikely they will do this, since they do not want to tighten domestic monetary conditions at present. Therefore the balance sheet will increase, in sharp contrast to what happened under “Operation Twist”.
When any news is good news
Clive Crook notes that the reaction to the central-bank initiative could have gone either way. Since the move shows how anxious the monetary authorities are about what might be coming next from Europe, I wasn't especially reassured. If you see emergency workers stockpiling sandbags and bottled water, is that good news or bad?
Paul Krugman is somewhat mystified. Of course the Fed will make dollar liquidity available to other central banks as needed; that was never in question, because Bernanke doesn’t want to be the man who destroyed the world to save a few pennies. And reducing the
interest rate on those loans seems to me to make virtually no difference; it was a trivial charge anyway. So this looks to me like a non-event. Yet markets went wild.
Mohamed El-Erian writes that risk markets love liquidity injections, real and perceived. They also like the possibility that this dramatic coordinated move provides a stronger context for further actions at the level of individual institutions. The hope is that central banks are acting because, looking forward, they feel confident that other policymakers will finally catch up with a big and spreading debt crisis that has serious implications for growth, jobs and inequality. The fear is that they are acting because they feel that they must again pre-empt yet another set of potential disappointments.
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