As we noted last week, analysts have been tittering over a new potential policy response to risks associated with a global slowdown—most particularly the crisis in Europe.
World leaders are worried, as evidenced by the conference call between G7 finance ministers and central bankers this morning. And with fears about bank runs in Spain escalating, some analysts expect some kind of coordinated central bank action similar to that which we saw announced last November to lower dollar swap rates between banking systems.
That program lowered the rate at which the Federal Reserve loans dollars out in exchange for foreign currency and gets them back at the same exchange rate plus interest. Central banks currently pay 50 basis points above the rate at which U.S. banks can hedge against currency risk, but lowering this premium could help struggling banks to meet dollar funding demands.
“I think [coordinated action] is a lock, so I would expect they will announce it at the next opportunity,” Andrew Hofer, Head of Fixed Income at Brown Brothers Harriman told Business Insider Monday.
And it’s likely that an expansion of the dollar swap program—and not quantitative easing—would have a much more important effect on the global economy.
“We can deal with unemployment, but at this point we can’t have banks collapsing in Europe as Lehman Brothers did in 2008,” said Larry McDonald, author of A Colossal Failure of Common Sense—The Inside Story of the Collapse At Lehman Brothers and Senior Director of Credit Sales and Trading at Newedge, in a phone interview.
He continued, “We don’t know if behind the scenes if there’s a struggling eurozone bank in ‘critical condition.'” I think the Fed expanding swap lines to the ECB and banks in Europe could happen any time Bernanke sees a bank failing in Europe. This would be done not to prevent a bank from falling but to control the spread of systemic risk.”
MacDonald added that investors have probably underestimated the impact of a similar intervention last fall, lumping all the credit on the European Central Bank’s two 3-year LTROs.
Those actions have helped make typical indicators for systemic funding risk deceivingly low. That’s because they are a composite of lending rates for many other banks. Take a look at the 3-month EURIBOR—the benchmark rate at which a sample of banks borrow for a fixed term—which is near 3-year lows:
Such numbers completely ignore the fact that money is rushing out of some banks and into others—just look at the flight to safe assets in German and French bunds.
Further, data on international claims from one bank to another is depressingly slow. Fourth quarter 2011 data from the Bank of International Settlements (pdf) was just published last weekend, and the prognosis was pretty grim for the state of European banks:
During the fourth quarter of 2011, BIS reporting banks recorded their largest decline in aggregate cross-border claims since the drop in the fourth quarter of 2008, which followed the collapse of Lehman Brothers. The latest decline was worldwide but largely driven by banks headquartered in the euro area facing pressures to reduce their leverage. Overall, cross-border lending to non-banks decreased; but the decline of claims on banks was sharper – and the largest in almost three years.
In developed countries as a whole, total cross-border lending to banks and non-banks contracted by $630 billion; the most notable exceptions were Japan and Switzerland, where it increased by $71 billion and $13 billion, respectively. The decline was led by a significant drop in interbank lending arising from the spillover of the euro area sovereign debt crisis to bank funding markets. The reduction was especially marked for cross-border claims on residents of the euro area and was mostly attributable to euro area banks.
Means of boosting interbank lending are fundamentally different than those for boosting the economy directly. While the European Central Bank may have incentives to cut rates to address unemployment concerns, one particularly bad jobs results and vaguely negative economic data might not be enough to spark another round of easing.
Further, Hofer (among others) does not believe that quantitative easing would have any significant impact, regardless of the falling inflation and bad employment data that have excited analysts about the prospect of imminent QE3. “We’re at all time lows in the 10 year. We don’t need QE3 right now,” he said.
That said, temporarily mitigating interbank lending concerns could prevent systemic risk from spilling over into equities markets and the real global economy. “An economic slowdown is one problem. It’s when it becomes systemic that it becomes deadly for stock market performance, which exacerbates an economic decline,” MacDonald argued.
“I think behind the scenes Obama is very concerned. Rising systemic risk from Europe is the greatest threat to his reelection,” he added.
Whatever the likelihood of imminent coordinated bank intervention, it is important to remember that central banks’—and particularly the Fed’s—powers are expansive and not limited to QE.
While we’re talking about European banking problems…14 Reasons Spain Is Turning Into A Disaster >