JPM Explains The Novel Feature In Today's Fed Liquidity Swap Line Expansion
As JPM's Michael Feroli, he move to cut the Fed's swap lines rate from OIS+100 to OIS+50 should not come as a surprise: it was already in the works, the only question is when it would be enacted. As it so happens it was decided on Monday, and was announced today after unfounded rumors of a potential bank failure in Europe became apparent. There was however a twist: "The new foreign liquidity swaps, whereby the Fed can offer euros, yen, loonies, pounds or swiss francs to US banks, is a novel step and a curious feature of today's announcement. The Fed's official statement is that these are being implemented as a "contingency measure." There are no plans to make these operational in the near term, but are apparently being set up as a backup plan in the event of a worsening in global financial conditions." What this means remains unclear but the Fed never changes policy without reason. Which then begs the question: while everyone is focusing on foreign bank lack of USD liquidity, should the real focus be on US bank lack of foreign currency liquidity?
The Fed took three actions this morning to support global financial markets: the first and by far most important was lowering the interest rate charged on its dollar liquidity swap lines with the ECB and other central banks from OIS+100bps to OIS+50bps, second it extended the availability of those facilities from August of 2012 to February of 2013, and third it has agreed with other central banks on creating swap lines whereby the Fed can lend foreign currencies to US financial institutions.
Regarding the first of these moves, there had been a fair bit of speculation that the Fed would lower the interest rate charged on these lines, though the timing of such a move was uncertain. Throughout the crises there has been a relatively low hurdle for introducing or making more generous the swap lines, which may be due in part to the fact that such swap lines have historically been considered a normal part of the Fed's toolbox. In addition, the Fed takes no credit risk with these swap lines, as it faces the ECB, not the private European banks that draw on these lines. So from a purely pecuniary view -- which is what is not what is motivating the Fed -- the reduction in the 50bps earned on the lines could be offset by an increase in the amount of risk-free lending done through the swap lines. (We are sometimes asked who is liable to the Fed if the eurozone were to disband. This is not specified in the swap agreements -- which are posted on the NY Fed website -- as seems appropriate given it is still a pretty far-fetched contingency. Presumably the national central banks that comprise the eurosystem would still be liable).
Any increase in usage of the swap lines will result in an increase in reserves held by the US banking system: for European banks that do not have accounts at the Fed, liquidity is provided through US correspondent banks. The fact that the discount rate is 75bps whereas OIS+50 is under 60bps creates some odd optics, as it is cheaper now for European banks to borrow dollars from the ECB than for US banks to borrow dollars from the Fed. The press releases states that "U.S. financial institutions currently do not face difficulty obtaining liquidity" but if conditions deteriorate the Fed has tools which they "are prepared to use," -- which we read as saying a cut in the discount rate is not imminent, but would readily be forthcoming if US banks began to face funding difficulties as well.
The new foreign liquidity swaps, whereby the Fed can offer euros, yen, loonies, pounds or swiss francs to US banks, is a novel step and a curious feature of today's announcement. The Fed's official statement is that these are being implemented as a "contingency measure." There are no plans to make these operational in the near term, but are apparently being set up as a backup plan in the event of a worsening in global financial conditions.
Richmond Fed President Lacker (voting in Plosser's place) dissented. Not too much should be read into this, as he has always had an issue with swap lines, having in the past voted against the long-standing North American lines of $2 billion with the Bank of Canada and $3 billion with the Bank of Mexico.
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