The European Central Bank and a posse of other big official lenders are attempting to chase fear out of global financial markets and reduce strains on European banks by pledging Thursday to ensure that they can access U.S. dollars. Here's how this works.
Every day, banks around the world use U.S. dollars (the global reserve currency) to settle tens of thousands of transactions. Fears about many European banks' exposure to Greek debt are making it hard for them to find dollar funding in the inter-bank market.
On Oct. 12, Nov. 9 and Dec. 7, the ECB will make U.S. dollars available for three-month loans, complementing a seven-day loan facility that's been in place since May, 2010. The longer duration is meant to provide certainty that banks have access to enough dollars to settle accounts, avoiding a scramble in funding markets that drives up borrowing rates.
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The Bank of England, the Bank of Japan and the Swiss National Bank made similar announcements Thursday. Those central banks and the ECB will work in co-operation with the U.S. Federal Reserve, which maintains something similar to lines of credit with central banks that allow them to swap their currencies for dollars.
The central banks essentially sell their currency to the Fed in exchange for dollars, and then lend the dollars to financial institutions in their jurisdictions. At the end of the three-month period, the central banks would swap the dollars with the Fed for their currencies at a fixed exchange rate. If the central banks loan dollars to financial institutions, they will do so at "punitive rates," in this case the market interest rate for securities known as three-month overnight index swaps, plus a premium of 100 basis points.
The reason for that premium is to push banks to access liquidity through the private sector, except when uncertainty and nervousness in financial markets is making it harder for some to get all the funding they need. There is also a built-in disincentive from using the facilities, in that banks don't like to advertise that they are experiencing a crunch.
Next week's tender for seven-day dollar funding and the Oct. 12 auction for three-month loans will show how much pressure European funding markets are under. Already, lenders are hoarding cash and demanding prohibitively high rates in return for funds. Two banks borrowed dollars from the ECB this week in the seven-day loan operation, a sign money is harder to come by in private markets.