To recap, most global banks have dollar assets and liabilities, hence a
sizeable appetite for dollar funding. Usually, they can get it in the
interbank markets. But when all hell breaks loose, as it did back in the
summer of 2007, foreign banks are suddenly exposed.
US banks have large dollar deposit bases to draw upon, and a direct line to
the Federal Reserve back home. During the last crisis, however, the spread
between the borrowing rates for the 13 non-US banks which help set the
so-called Libor “interbank” rate and the rate for the three US banks on the
same panel suddenly ballooned from nothing to more than 30 basis points,
indicating that foreign banks were scrambling for dollars.
Why didn’t Europe’s central banks simply sell their foreign exchange reserves
for dollars to help fund their banks? In retrospect, according to a New York
Fed paper, most central bank forex reserves were not big enough. Besides,
central banks buying dollars crowds out the very banks that also need them.
Only Fed can help
Hence, at such times, only the Fed can help, using a system whereby foreign
central banks “swap” their currencies into dollars for a small interest
rate. Local banks then bid for those dollars and, at the end of a period,
they are swapped back at the same exchange rate.
At the height of the crisis in December 2008, the swaps outstanding reached an
incredible $600bn, a quarter of the Fed’s entire balance sheet.
The recent shambles in Europe has brought a return of funding worries. One
measure, the difference between the cost of privately swapping euros from
the interbank market into dollars and borrowing dollars direct, has been
rising. Hence, Wednesday’s announcement that currency swap lines would be
broadened, extended and made cheaper for all involved.
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