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.