Central banks take action to increase liquidity
In a display of co-ordinated action from major monetary authorities the interest rate on dollar liquidity swap lines was lowered by 50bp
The US Federal Reserve, the Bank of England, the ECB, the Bank of Japan, the Bank of Canada and the Swiss National Bank agreed yesterday to lower the interest rate on dollar liquidity swap lines by 50bp. This brings the new rate equal to the US dollar overnight index swap (OIS) plus 50bp. In addition, these swap arrangements were extended to 1st February 2013.
Essentially, this amounts to the US Fed reducing the rate that it charges central banks on dollar liquidity by 0.5%. Cheaper dollar swap lines should enable the ECB to in turn provide cheaper dollar loans to European central banks; as a result, bank funding pressures should ease, reducing their need to curb lending to households and businesses, and thus lowering the impact on the real economy. Other central banks also loosened monetary policy, in response to worsening economic prospects; China reduced its reserve ratio by 50bp, and Brazil cut interest rates by the same amount.
The move towards cheaper dollar liquidity has been seen as a tacit admission that the existing swap lines were not attractive to European banks; indeed, only a comparatively small $2.4bn was drawn on them last week. The main reason for this is an avoidance of the stigma of borrowing directly from the central bank rather than through money markets, which could possibly spark further concerns over individual banks’ solvency.
While this may limit the total amount that may be borrowed, the move was overall generally welcomed – both in terms of easing strains in financial markets, and as an important display of international co-ordination. The ECB’s additional announcement of reducing the initial margin on dollar loans from 20% to 12% (i.e. demanding less collateral) was also deemed positive.
Market reaction following the announcement was positive, with global equity prices rising sharply. However, it is unclear as to whether this rally will be sustained. Following similar action in 2008, the rally did not last and the market turned decisively only when banks were recapitalised and concerns over solvency were allayed.
Also while the move eases pressures on liquidity provision, it doesn’t address the fundamental concerns over the solvency of European banks and the exact role that the ECB may take as some form of lender of last resort.