Euro Crisis Makes Fed Lender of Only Resort as Funding Ebbs
The Federal Reserve, chastised by Congress for lending money to foreign institutions including a Libyan-owned bank, is once again the lender of last resort for banks around the world it knows little about.
Three years after the collapse of Lehman Brothers Holdings Inc., money-market borrowing rates for dollars are rising, leading the Fed and European Central Bank to make the currency available to Europe’s institutions for as many as three months. U.S. prime money-market funds cut their exposure to euro-zone bank deposits and commercial paper, or short-term IOUs, to $214 billion in August from $391 billion at the end of last year, according to JPMorgan Chase & Co. data.
The failure of regulators worldwide to address European banks’ fragile dependence on short-term funding is “putting the Fed in a really awkward position,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington regulatory research firm whose clients include the biggest U.S. banks. The swaps with Europe “are an extremely advantageous political football” for critics of the Fed, she said.
The extended funding comes as the U.S. central bank is already under fire for its unprecedented monetary stimulus. Republican leaders including Representative John Boehner of Ohio and Senator Mitch McConnell of Kentucky wrote Chairman Ben S. Bernanke and the Board of Governors on Sept. 19, asking them to “resist further extraordinary intervention in the U.S. economy.”
Representative Ron Paul, a Texas Republican who wants to abolish the Fed, and Senator Bernard Sanders, a Vermont independent, have criticized its loans to foreign institutions.
“The Fed has made good on most of its investments over the years, but increasing its exposure and that of the U.S. government to foreign banks is a moral-hazard problem,” said Edward Royce of California, the third most-senior Republican on the House Financial Services Committee. “We are effectively incentivizing U.S. money-market funds to continue to finance these banks.”
U.S. regulators also are becoming less patient with what are turning out to be dollar-funding runs against foreign banks. Financial institutions are too dependent on short-term money- market investors that tend “to flee at the first signs of distress,” William C. Dudley, president of the Federal Reserve Bank of New York, said Sept. 23 in a Washington speech.
Regulators also lack access to data on foreign institutions operating in the U.S. that would allow them to “make informed judgments about the adequacy of such firms’ capital and liquidity buffers,” he said.
Investors are fleeing because of concern that banks will take large losses if a euro-zone nation such as Greece defaults. Europe’s debt crisis has generated as much as 300 billion euros ($407 billion) in credit risk for the region’s banks, the International Monetary Fund said last week.
Against the euro, the dollar is heading for its biggest monthly advance since November last year as European policy makers fail to contain their region’s sovereign-debt crisis. The euro traded at $1.3606 as of 1:25 p.m. today in New York.
The London Interbank Offered Rate at which banks say they can borrow for three months in dollars rose for a 14th day today to 0.36856 from 0.36522 percent yesterday, according to data from the British Bankers’ Association.
The ECB said Sept. 15 it will coordinate with the Fed and other central banks to provide three-month dollar loans to banks to ensure they have enough of the currency through the end of the year. The Fed bears no foreign-exchange or credit risk on the swap lines because the Frankfurt-based ECB is its counterparty.
There were $575 million in outstanding swaps with foreign central banks as of Sept. 21, Fed data show. The ECB loaned a similar amount of cash to two euro-area banks earlier this month in seven-day transactions. The first of three ECB three-month dollar-loan offers starts Oct. 12.
The Fed facility provides a critical “ceiling” on funding squeezes that allows investors to avoid panic and distinguish between healthy and troubled banks, said Jerome Schneider, head of the short-term strategies and money-markets desk at Pacific Investment Management Co. in Newport Beach, California.
“What you don’t want to have is liquidity risk become intertwined with solvency risk,” Schneider said. The swap lines are “the foundation right now to provide a backstop.”
After the criticism earlier this year of lending to overseas institutions -- including Arab Banking Corp., part- owned by the Central Bank of Libya, after Lehman collapsed in 2008 -- New York Fed researchers said U.S. branches of foreign banks were among the biggest borrowers from the discount window because they lack deposit bases. The window is the Fed’s oldest backstop-lending tool.
In an April 13 post on the New York bank’s research blog, the researchers said these institutions have relied more heavily on so-called wholesale funding for dollars, including the money markets and foreign-exchange swaps. Supporting these banks helped maintain foreign investment in the U.S., they said.
The Fed “does need to be concerned about how a liquidity run on the European banks will impact us -- our financial markets, our financial institutions, the economy as a whole,” said Republican Representative Kevin Brady of Texas, the vice chairman of Congress’s Joint Economic Committee. It needs to define its safety-net policies and use the extension of its credit as a lever to persuade European regulators to work on funding stability, he added. He will call on Bernanke to address these concerns at an Oct. 4 hearing, he said.
“The Fed’s lack of a lender-of-last-resort policy really does create tremendous market uncertainty” and provides an incentive for institutions “to run to the politicians,” Brady said. “It does create moral hazard, no doubt about it.”
Euro-zone banks and other institutions were more than $350 billion in debt to the Fed’s emergency-lending facilities at one point during the 2008-2009 financial crisis, according to data compiled by Bloomberg News. The analysis was based on Fed documents released earlier this year after court orders upheld Freedom of Information Act requests by Bloomberg LP, the parent company of Bloomberg News, and News Corp.’s Fox News Network LLC. Fed lending to these entities totaled more than $100 billion on an average day.
Dexia SA (DEXB), based in Brussels and Paris, was the biggest euro-area borrower, with as much as $58.5 billion of Fed loans on Dec. 31, 2008. BNP Paribas (BNP) SA in Paris borrowed as much as $29.3 billion on April 18, 2008. The largest U.S. borrower, New York-based Morgan Stanley (MS), took $107.3 billion of loans on Sept. 29, 2008.
Banks that rely on unstable short-term funding risk having to return to official sources for money until liquidity and capital are bolstered, said Viral Acharya, a New York University Stern School of Business professor and author of books on financial stability.
“All the national regulators have to agree that their banks need to raise capital,” he said. “The regulators are not sufficiently united. No one country is taking the leadership to realize the problem is getting out of hand.”
The Basel committee said today it would speed up work on a minimum liquidity rule designed to make lenders more resistant to a short-term funding crunch. Work on “key areas” of the so- called liquidity-coverage ratio now will be completed “well in advance” of the original mid-2013 deadline, the committee said. The measure is scheduled to take effect in January 2015.
While the Fed is legally required to lend to banking entities in its districts, it “does have a choice” regarding how it will extend the swap lines, said William Poole, former president of the Federal Reserve Bank of St. Louis.
“European governments have substantial dollar holdings of U.S. Treasury securities, so why not sell some of their dollar securities to support their own banks?”
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