Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Tuesday, September 27, 2011

European banks and US dollars

I sometimes get asked why European banks are in apparent need of US dollars, and why the Fed is lending money to the European Central Bank (ECB).

Ah, the wacky world of international finance. I can't pretend to understand it fully--or even very well--but here are some thoughts nevertheless. (I'm learning a lot about this stuff from my colleague, Richard Anderson, but still lot's to learn!)

We have all heard about the apparent troubles European banks are having. They have (we believe) invested in the sovereign debt of fiscally strapped nations like Portugal and Greece; see here. Fine, you say. This might explain why they need short-term Euro financing, which the ECB can in principle supply. What the heck do they need USD for?

Well, evidently, European banks do not invest just in Europe. They also lend to companies operating in the US. Where do they get the USD to do this? A big source of  funding apparently comes from U.S. money market mutual funds (MMMFs), which lend funds to branches of these foreign banks residing on US soil. (All of this somehow is governed by the US 1978 International Banking Act -- if you understand how, please write back!)

Now, when things start to look scary in the financial market, credit begins to tighten. And it looks like the American MMMF industry is running scared from Europe. Here is an interesting tidbit, published by the Investment Company Institute (ICI), an enterprise described to me as the "public face of the U.S. MMMF industry" The piece is called Deja vu--US Money Market Funds and the Eurozone Debt Crisis (by Chris Plantier and Sean Collins). Here is an excerpt:

Direct exposure to both public and private issuers in the European “periphery” countries is virtually zero. Since June, U.S. money market funds have almost eliminated holdings of Italian and Spanish government and private debt, including bank securities. 
U.S. money market funds have reduced the maturity of their holdings in banks in Europe’s “core” (France, Germany, the United Kingdom, and other countries). According to JP Morgan Securities, 60 percent of U.S. prime money market funds’ holdings in French banks as of the end of August will mature in 30 days or less, compared to 28 percent of their holdings at the end of June. Shorter maturities provide flexibility and reduce the impact of any potential downgrades. 
According to Crane Data, at the end of July, 69 percent of money market funds’ holdings in German banks and 67 percent of holdings in British banks were set to mature in 30 days or less.

So, MMMFs are shortening the maturity structure of their lending to European banks (and raising rates). This makes European banks more susceptible to a "rollover freeze"--an event where short-term financing collapses altogether. This is the "Lehman event" that policymakers worry about for Europe.

The policy response to date has been for the Fed to re-activate its swap line with the ECB. If you go to some websites and blogs, they might describe this operation as the Fed "creating money and pumping it into Europe." One could equally well describe it as the ECB "printing up Euros and pumping them into the US." That is, at its most basic level, the two central banks are simply exchanging "green money" for "blue money." This is the nature of a swap (for those who are prone to confusing the word "swap" with "gift").

I should like to point out a fact that is seldom emphasized. The dollars that the Fed lends to the ECB through the swap line are fully collateralized (and hedged against currency risk). The ECB gives the Fed Euros in exchange for USD; the operation is then reversed a short time later (and the Fed generally earns a small return for its service). The ECB then takes these dollars and lends them those European banks "in need" of short-term USD financing--including those European banks operating on US soil, making loans to US businesses. (Essentially, the ECB is subsidizing European banks--and it is the ECB that bears the risk, not the Fed.)

Is this policy response by the Fed and the ECB justified? That's a tough one. As usual, one can make arguments pro and con.

On the pro side, one might note that US MMMFs have become somewhat skittish since the 2008 financial crisis. (You might remember an MMMF "breaking the buck" on Lehman's IOUs; see here.) They are now
very sensitive to adverse publicity about the firms they lend to (that is, invest in).  And now, it is evidently the case that banks with foreign names, even if located on US soil, might "sound" risky.

From a purely economic standpoint, this credit contraction seems a little hard to understand (but then again, who are we to argue with how creditors want to bet their money?) It is my understanding, for example, that the short-term loans issued by U.S-based branches of European banks to American companies are fully collateralized (by American capital). If this is true, and if American industry is showing no signs imminent distress, then why should a potential haircut on PIIGS debt (borne by European banks) have the American MMMF industry sufficiently worried to pull their financing (of American industry) on such a dramatic scale? Are these fears overblown? And might such overblown fears increase the likelihood of a Lehman-style event for European banks?

On the con side, we have the usual arguments for why policymakers should just let the market get down to business and resolve any outstanding credit issues. Claims of imminent contagion are made largely to justify transfers of wealth (bailouts). Moreover, there is a possibility that policy interventions, like the Fed-ECB swap line, simply delay the inevitable debt restructuring that is presently necessary. 


  1. European banks also lend to European companies (operating in Europe) that need USD - not just US companies operating in the US. An obvious example is a European airline buying oil.

  2. Anonymous, I'm sure that's the case. But I think my point was that US MMMF is pulling out of ABCP that is backed by US capital, just because the commercial paper is, in this case, managed by a European bank operating on American soil.

  3. This really doesn't answer the question of why the swap line is needed. If European banks need dollars to replace lost funding, why don't they borrow Euro's from the ECB and exchange them for dollars in the FX market? In emerging markets debt crises, we call such a plan a "maxi-deval".

    So by supplying dollars, it seems the Fed is trying to stop the dollar from appreciating against the Euro. It is less clear how this helps Europe, which at this point would seem to benefit from a hefty devaluation.

  4. David Pearson:

    Those are excellent questions! I do not know the answer.

    If it is the case that your proposal leads to a large Euro devaluation, some insurers are going to be suffering big losses. That's the way it should be, one may argue. But then people bring out the old bogeyman of "counterparty risk," etc. It all sounds a little fishy, doesn't it?

  5. I think the problem is debt-driven devals (caused by bank hard currency "shortages") can get pretty disorderly. Oct/Nov of 2008 was one example when dollar strength and real rates got out of hand. Still, I know of few countries that have managed to get out of sovereign debt crises without disorderly devals.

    The 90's Latin analogy is interesting. Brazilian banks made dollar loans to domestic companies funded by global bank dollar lines. When the lines got pulled, the mad scramble for dollars created devals. This is no different than what is happening now, except that the European banks are making dollar loans to foreigners, and their dollar MMF funding got pulled.

  6. David, the example of Brazil sounds very interesting. I wish I knew more about it. Can you recommend an article describing the episode?

  7. David,

    I worked in Latam banking and then managed a Latin America mutual fund in the 90's, so I'm afraid this is all from memory.

  8. "If European banks need dollars to replace lost funding, why don't they borrow Euro's [sic] from the ECB and exchange them for dollars in the FX market?"

    1. the banks need the appropriate collateral to borrow EUR from the ECB.
    2. as you well know, trades require counterparties. if none are willing to trade with you...

  9. Anonymous,

    The Fed Swap line is to the ECB, not to individual banks. I imagine that, just as for Euro's, the banks must put up collateral with the ECB to obtain dollars.

    Are you implying that banks such as Soc Gen or BNP cannot trade in the FX market? Surely the vast majority of E. banks are still active FX counterparties.

  10. "I imagine that, just as for Euro's [sic], the banks must put up collateral with the ECB to obtain dollars."


    "Are you implying that banks such as Soc Gen or BNP cannot trade in the FX market?"

    No, I'm not. But the ECB has literally thousands of counterparties, not all of whom are 'good signatures' that the market is willing to trade with.

  11. I think one have to look at the dollar balance of EU. EU has a trade surplus of 80 bn. $'s with US. I cannot find any figures for EU's oil imports. They are certainly denominated in dollars. We can assume that all the dolar gains of EU from the next exports to US is sucked up by its oil imports.

    What about the EU trade with china? Is it denominated in dollars or in euros? I cannot find any info on that, but I assume that some of the EU imports from china is denominated in dollars.

    Hence, in overall, we arrive at a paradoxical situation: while EU enjoys a trade surplus with US, it experiences a deficit in dollars.

    EU can easily rectify this situation by devaluing euros via purchases in forex market, as mentioned by David. This will also help their factories, jobless rate etc. I believe that why they dont do so is more to do with politics rather than economics.

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