The U.S. Federal Reserve has been pumping billions of dollars into the European banking system in recent weeks in an attempt to help stabilize the continent’s financial crisis. And while the effort remains small, it is likely to grow in coming days as Europe’s banks struggle to find lenders willing to help them service their dollar denominated debts.
The Fed’s effort has two parts. The largest by far is its provision of dollars through swap lines the Fed opened to other central banks around the world during the 2008 financial crisis, and reopened in May 2010 when the European sovereign debt crisis blew up. According to the agreement [PDF] signed between the New York Fed and the European Central Bank, the ECB can swap Euros for dollars at a fixed exchange rate and repay the Fed with nominal interest at an agreed upon date.
For months the swap lines remained idle, but last September the European Central Bank announced it would tap them to help provide dollars to banks in Europe, and it began rolling over about $500 million worth of swaps every 7 days at a little over 1% annualized interest. In mid-October the ECB increased its swaps, drawing $1.35 billion for three months, while continuing to rollover the previous $500 million. Over the following weeks it swapped another $1 billion in 1-week and three-month paper, bringing the outstanding total to $2.35 billion as of Nov. 16.
That is a tiny amount in the multi-trillion dollar world of transatlantic money flows, and it shows that in some ways the Fed move to ensure its vast store of dollars are available to the European banks through this channel is working. “The hope is that when you put the big bazooka [of Fed dollars] on the table that you don’t have to use it,” the source says. But the uptick in swap line use shows it is becoming harder for European banks to get their hands on dollars from lenders, and suggests, as the source says, that at some point the bazooka “may have to be used.” Since the Nov. 16 report on swaps was released by the New York Fed, interbank lending in Europe has further worsened.
The European banks are trying hard to avoid using the second measure the Fed has made available to some of them: drawing off the discount window in the U.S. Since the 2008 financial crisis, the Fed’s discount window has remained open to all U.S. banks, and to all foreign banks that have branches or agencies here. Virtually no one is currently drawing on that source—there was $4 million outstanding as of Nov. 16—because it is a sign of ultimate collapse for a bank to have to do so.
For all the Fed’s willingness to back-stop European banks there is only so much it can do. The European banks’ problems are not primarily with their dollar-denominated debts, but with their Euro debts. They are currently drawing 500 billion Euros off the ECB in an effort to service their debts. In recent weeks, Italian and other banks have pushed the ECB to accept less reliable forms of collateral for loans they take from the ECB. The ECB in the past has accepted such collateral, down to office furniture, for countries receiving help from the IMF, but is only now loosening the restrictions for bigger countries like Italy. With the loosened requirements, the ECB has the potential capacity to lend 14 trillion Euros.
The Fed’s effort is a worthwhile risk since the U.S. has a huge economic interest in keeping dollars available worldwide. The U.S. has $1.28 trillion in exports every year, and the vast majority of those purchases are made in dollars—ensuring there are enough dollars in circulation to keep that commerce going is important. Likewise the discount window protects the flow of dollars at home: in 2006 foreign banking institutions held around 18% of U.S. commercial and industrial loans.