Last week, five central banks joined to announce a plan to grant European banks easier access to US dollars. At least in the near term, this should help relieve some of the pressure on European banks, which have found it increasingly hard to borrow dollars over the past year.
European banks still have plenty of capital (as Fisher Investments explained recently in this article on The Street), but much of it is in euros and other assets. Since a good deal of international business is conducted in dollars, European banks need an ample supply of dollars for lending and other normal operations. Historically, they have borrowed significant amounts of these dollars from U.S. domiciled money-market funds, using euros as collateral. However, as US lenders have grown increasingly concerned in recent months about the eurozone periphery’s ongoing debt problems, they’ve been less willing to accept euros as collateral. This in turn has driven up interest rates for dollar loans collateralized by euros, making these loans more expensive for European banks.
These dollar funding difficulties have caused some to speculate about the potential for an oncoming self-fulfilling prophesy: If a bank can’t access funding, it may be perceived as too risky to lend to, and it may not receive the capital it needs to continue doing business, which could cause a liquidity shortage. If this happened many times in a short period, Europe could find itself in a banking crisis.
No one wants this, and the central banks believe they have a solution. In a coordinated action, the US Federal Reserve and European Central Bank, along with the central banks of Britain, Switzerland and Japan, will provide unlimited dollar liquidity for any bank that asks for it. The central banks will swap dollars for other eligible collateral, with terms of approximately three months, at a low fixed rate. This will happen three times, on October 12, November 9 and December 7.
Though this move won’t solve Europe’s peripheral debt problems, it should help ease lending risk in the near term, which is a positive development. Additionally, it demonstrates financial leaders’ resolve to help global capital markets function as smoothly as possible while European leaders continue working on a solution, which could boost the market’s confidence.