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Friday, September 16, 2011

I need a dollar...

Five central banks, including the Bank of England (BoE) and the European Central Bank (ECB), announced yesterday that they would provide unlimited three month dollar loans to their banking sectors. Although we've been fairly critical of the ECB during this crisis, we've often maintained that many of its actions were taken out of its hands by the lack of action on the part of eurozone leaders. This is a prime example of such a situation.

The decision won't change any of the underlying problems in the European banking sector - many banks still need to be recapitalised, some need to consolidate and deleverage and they all need to fully realise and account for potential losses from the eurozone crisis. That said there are also unlikely to be many negative side effects from this dollar provision, especially since the likes of the ECB were already providing unlimited liquidity anyway.

Below are a few of our thoughts on the issue (specifically in reference to the ECB's role):
- The mechanism is the same as the standard lending practices but in dollars, so the credit risk is the same as normal liquidity provision but with some small additional foreign exchange risk, however this should be priced into the lending rate to banks and (probably) into the collateral requirements.

-It doesn't count as monetisation as it is directly replacing the dollar funding lost from the hesitancy of the money market funds in the US who used to provide these loans to banks. In very recent times the collateral used was widely accepted on the market so there is less to worry about in terms of quality.

- The concerns surrounding the withdrawal of lending to UK and European banks are not directly based on the banks health for the most part, but mostly the lack of eurozone leaders' ability to deal with the crisis and the fall in growth across Europe. Exactly the type of situation where central banks should intervene for liquidity purposes. (There is obviously some concern over these banks' exposure to the debt crisis, but that does not fully account for the complete lack of funding while also does not often directly affect the quality of collateral they can offer for dollar lending).

- It is essentially only an extension of the existing facility. The ECB was already offering unlimited weekly loans, now it has just extended this to 3 months. This offers added security and reduces the cost of continuously rolling over the short term funding.

- If they didn't receive this funding in dollars the banks would probably have borrowed in euros and arranged foreign exchange swaps to gain dollars. Essentially, it looks to us as if the ECB is basically taking on the exchange rate risk for the banks. This is a fairly small price to pay (and may be covered in the lending rates as mentioned above) and is much easier for the central banks to manage, especially with their direct lines with the Fed, than individual banks.

- One issue is that it removes the stigma of borrowing dollars from the ECB's one week funding mechanism. This could have a negative impact to some extent as it increases moral hazard as it may encourage banks to borrow more regularly from the ECB.

- Could become problematic if the ECB has no exit strategy. The lending rate needs to be high enough so that when some semblance of market confidence returns, the banks go back to borrowing from elsewhere and don't stay reliant on the ECB. (This mechanism was used and wound down again in 2008 and early 2010, so there is at least some precedent that it can be used temporarily).

- It is likely that most of the BoE lending will go to UK banks, or the UK arms of global banks, so unlikely that the UK will be directly funding European banks - a concern expressed by some. In any case, its a global coordination and would have been hard for the UK to avoid no matter its position in Europe, its also likely that this role would fall onto central banks when you have a global financial system with numerous heavily used currencies (and one key reserve currency).
All in all, the introduction of this mechanism doesn't change much, particularly in terms of the risks for the ECB. Any underlying problems can mostly be traced back to issues with the existing unlimited liquidity provision by the ECB, but that is a whole other story...


Rollo said...

There is a big difference between lending in US compared to lending in Old Euros: The ECB can just print off more Old Euros, but will have to find the dollars. It is in reality just another way of taking debt from European financial institutions and lumping it on to the tax payer.

Open Europe blog team said...

Thanks for the comment Rollo.

In fact the ECB, along with other central banks, has a dollar swap line set up with the Fed. This allows it essentially unlimited access to dollars through loans or swaps. To get dollars, therefore, the ECB can either put up some of its assets of collateral or just the necessary level of euros for a currency swap. Clearly then it could simply print euros and swap them into dollars if it ever came to that, although probably a last resort. Essentially, the main risk here is a foreign exchange risk which the ECB is shouldering and some cost with the Fed for the dollar loans or swaps. These are minimal given the stability of the swap lines and can be passed on to those banks that borrow dollars from the ECB through the charges or rates on those loans.

You are undoubtedly right that it is another avenue for more collateral to be transferred to the ECB’s books, although as we suggest in the post not all of this is likely to be bad or risky (but some of course will). In any case if the banks needed this money bad enough they could always access the standard unlimited euro provision at the ECB and exchange it into dollars. Ultimately, it seems to us that the issues with the dollar liquidity are very much the same as those of the unlimited liquidity provision in general but on a smaller scale.