Currency swap lines from central banks come to the rescue

A coordinated effort by six central banks worked to ease funding tensions with European banks through bilateral swap programs so funding could be provided if needed through February 2013. Interest rates on borrowing costs from central banks fell about 50 bps based on the news.  The impact on stocks was immediate as the idea that central banks will stand ready to flood the market with liquidity has reduced funding pressure. The dollar dropped hard in response to the the new liquidity. It eased the pressure by European banks to find dollars.

Under the arrangement, similar to programs initially set-up in 2007 and used periodically over the last four years, the Fed will swap dollars (lends) to other central banks which will then lend the money to banks in their countries.

The Fed has an incentive to do this because a decrease in lending within the US by European banks will have a credit crunch effect on the US economy. The swaps were done at flat currency pricing so there is no exchange risk to the Fed. The foreign central bank will only pay interest to the Fed for the length of the swap.

The funding pressure on EU banks has increased as their institutional dollar funding sources have dried up. Money market funds and other banks do not plan to fund EU banks given their higher risk assessment. These banks have significant dollar assets which have to either be sold or funded. There is a clear credit crunch going on with European banks as they tighten credit for anything except funding at home. It would be natural during a crisis that financing will be focused in the home country.

The ECB has already seen an increase in their 7-day financing operations to European banks. At 265 billion euros, it is at the highest levels in two years.

The good news is that liquidity is going to be provided. The bad news is that liquidity is needed and there may be a growing solvency problem with EU banks.