Fed seeks European aid for dollar dilemma

The logic behind Friday's effort to boost the supply of dollar liquidity on both sides of the Atlantic is simple: when globally-integrated markets malfunction, they require international, not just national repair.

For the Federal Reserve, the dilemma is particularly acute. It has, in effect, two roles – as the dollar funding authority for the world, and the national authority for the US financial system. It is difficult for the Fed to perform either role effectively in current conditions without the support of other central banks.

Senior Fed officials are convinced that a large part of the pressure in the dollar interbank money market is coming from European financial institutions – even though this view is contested by European central bankers.

European banks, like their US counterparts, were active players in the dollar-denominated world of international finance in the good times before the credit crisis, sponsoring dollar-based investment vehicles and provided dollar-denominated back-up credit lines. These assets are now coming back on to the balance sheets of banks everywhere.

But unlike US banks – which have easy access to sources of dollar liabilities such as dollar bank deposits – the European banks are structurally short of dollars.

They cannot raise large amounts of funds as they used to in the asset-backed commercial paper market because this market is still largely frozen. So they are forced to bid aggressively for interbank dollar loans.

The Fed believes this is a major cause of the pressure on the dollar Libor-OIS spread – the premium charged on interbank loans over the expected US interest rate.

It already provides one month dollar loans to big European banks with subsidiaries in the US through its US liquidity support facilities. But it cannot supply dollars directly to smaller European institutions that do not have US subsidiaries, even though these banks may have the greatest dollar-funding needs.

The Fed could ignore the funding needs of European financial institutions on the grounds that it is the US national authority, not a European authority.

But in practice it cannot, for two reasons. First, it takes seriously its responsibility to underpin the dollar's dominant role in international finance. Ignoring the dollar-funding needs of non-US entities would undermine this.

Second, the dollar funding needs of European financial institutions can create huge problems for the US national markets and economy.

This is because so many US loans – to companies and to households – are based on Libor (the London Interbank Borrowing rate). Libor is set in London, based on borrowing costs for mostly European institutions.

If the European banks' borrowing rates go up, the costs of Libor-based loans in the US go up. So even if the cause of high Libor is stress at European rather than US financial institutions, it still has a negative effect on the US economy and frustrates the transmission of Fed interest rate cuts through the wider money markets.

This illustrates a rare downside of the dollar's role as the world's currency.

Hence the Fed's efforts to persuade the European Central Bank and the Swiss National Bank to act as its agents in Europe, distributing dollars to the much broader universe of European financial institutions that have access to liquidity supplied by their domestic central banks.

The ECB and the Swiss are unpersuaded by the notion that the dollar-funding needs of European financial institutions are responsible for the tension in Libor. They see the problems as largely from the US.

Recent dollar auctions in Europe under the existing currency swap arrangements indicate strong but not an overwhelming need for dollars. The European authorities see the money market strains as largely global in nature, and not restricted to any one currency. To them the increase in the supply of Fed loans in the US is just as important as the offshore loans in Europe.

But they agree with the Fed that international co-ordination between central banks is essential to tackle global market problems, and are willing to go along with the US plan in the hope that it makes some difference.

Additional reporting by Ralph Atkins in Frankfurt

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