Crescenzi: Fed Addresses European Bank Strains

Wednesday, 30 Nov 2011 | 10:36 AM ET

The coordinated actionsby the Federal Reserve and other central banks is aimed at the funding strains faced by European banks in what was becoming a modern day run on the banks. The run has differed from the run that George Bailey watched as he drove up to the Bailey Building and Loan in It’s a Wonderful Life, but it has been a run nonetheless. The world in fact has been playing a game of hot potato with European bank debt as well as European sovereign debt, and the only player with oven mitts to hold the hot potato is the world’s central banks.

Illustrating the run on European banks is the sharp reduction in exposures by U.S. institutional prime money funds to European banks. For years the prime money funds invested about 50% of their investable money in European banks. This lasted until June. Since then, data from Fitch indicate the tally has fallen to 35%.

Further evidence of strain has been in the inter-bank market, in particular LIBOR . Whereas in June the 3-month LIBOR hovered close to the 0.25% rate the Fed pays on excess bank reserves, it was today at 0.53%, indicating banks were having increased difficulty obtaining dollar funding. Moreover, forward rates on LIBOR were priced for 3-month LIBOR to eventually reach about 85 basis points and the trend was accelerating.

Keep in mind that any use of the Fed’s swap facility expands the Fed’s monetary base: all dollars, no matter where they are deposited, whether it be Kazakhstan, Japan, or Mexico, wind up back in an American bank. This means that any time a foreign central bank engages in a swap with the Federal Reserve, the Fed will create new money in order to make the swap. Use of the Fed’s liquidity swap line in late 2008 was the main cause of a surge in the Fed’s monetary base at that time. The peak for the swap line was about $600 billion in December 2008. Some observers will therefore say that the swap line is a backdoor way to engage in more quantitative easing .

The provision of liquidity is no substitute for other actions that Europe must take to solve its current woes. The world continues to wait on European actions on fiscal rules, discipline, and enforcement as well as use of the balance sheet that matters most in the current situation: the European Central Bank . It remains a fact that Ben Bernanke is one of the few true deciders these days on the global policy stage.

Tony Crescenzi is Executive VP, Strategist, Portfolio Manager PIMCO. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Beyond the Keynesian Endpoint,""The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."