Central Banks Announce Bold Move to Rescue Europe
Business + Economy

Central Banks Announce Bold Move to Rescue Europe

iStockphoto/Getty Images/The Fiscal Times

The world’s major central banks unveiled a new strategy Wednesday morning to create a wall of money that could prevent Europe’s financial woes from undermining the stability of the global banking system.

The Federal Reserve, European Central Bank and central banks in Canada, Britain, Switzerland and Japan said in a joint announcement that they will extend the timing of and lower the interest rate paid on “swaps,” arrangements that have been used intermittently since late 2007 to funnel dollars to the banking systems of countries where there is need.

In effect, the Fed is handing over money to other global central banks — now at a lower rate than in the past — and those central banks, in turn, lend the dollars to banks in their countries that are facing difficulties funding themselves.

It is a step meant to arrest a creeping crisis of confidence in the world banking system, brought on by the heightening European debt crisis. The lack of confidence threatens major European banks and many of their counterparts elsewhere in the world.

“The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity,” the six central banks said in a joint statement Wednesday morning.

Stock markets in the United States and in Europe surged after the news was announced. The Dow Jones industrial average and the broader S&P 500 Index were up about 3.2 percent in early trading. The tech-heavy Nasdaq rose about 3 percent. In Europe, Germany’s DAX soared 4 percent. France’s CAC 40 was up 3.3 percent, while Britain’s FTSE 100 rose 3.1 percent.

The coordinated action comes as Europe, in particular, is in the grips of a growing credit crunch, making it harder for some companies — and households — to get quick, affordable access to cash.

European banks have seen their funding costs rise to the highest levels since the collapse of Lehman Brothers in late 2008. That, in return, has weighed on the region’s growth, increasing fears that constricted lending could plunge the continent back into a recession and deal another setback to the global economic recovery.

The swap lines are a global form of the central bankers’ role as “lender of last resort,” backing the world banking system.

It works like this: The Fed lends dollars to, say, the ECB in exchange for euros of comparable value. The ECB pays interest and lends the dollars to banks in the euro currency area that have obligations in dollars but are temporarily unable to borrow that currency to meet them.

Many of the European banks’ loans are in dollars. For example a company based in Asia that exports heavily to the United States might borrow dollars from a German bank to build a new factory.

However, the European banks’ funding—the deposits from their customers and the money they borrow on financial markets—is primarily in euros. In normal times, they can always borrow the dollars they need from another bank. But in a crisis, banks hoard their cash and are too fearful to loan it to each other. That’s what happened in the fall of 2008 and is, to a lesser degree, happening now.

A bank that has lots of dollar loans but can’t get enough dollar financing could get into trouble quickly. That’s where the Fed and ECB come in. The Fed lends dollars to the ECB, which in turn lends dollars to the troubled European bank.

The swap lines themselves were introduced in December 2007 in response to banks that were having deepening difficulties in funding themselves. They were used in vast amounts during the financial crisis in fall 2008 and were reintroduced in May 2010 when Europe’s financial troubles worsened.

But with the statement Wednesday, the Fed and other central banks agreed to make the terms of the swaps less onerous. The global central banks must now pay the Fed a private-sector overnight lending rate plus 0.5 percentage point; they previously paid the so-called overnight index swap rate plus 1 percentage point.

And the swap lines will now be in place until February 2013; they had been extended piecemeal.

Also, as a contingency measure, the central banks agreed to temporary swap arrangements with one another so that they can rapidly provide funding in currencies other than the dollar or their home currencies if necessary. For example, if Japanese banks suddenly needed Swiss francs, the Bank of Japan could swap yen for francs with the Swiss National Bank.

Other European attempts to ease the financial crisis have fallen flat. Plans to bolster the power of the euro zone’s bailout fund were not successful because few investors have expressed interest, in part because of difficulties borrowing money, feeding a cycle that has only worsened in recent weeks. Euro zone finance ministers acknowledged at a meeting on Tuesday that the bailout fund would not be enough to address Europe’s problems and suggested that the International Monetary Fund should take a larger role.

The problems in the European banking system could be seen on the books of the ECB. Banks are stashing in excess of $300 billion at the ECB in overnight accounts instead of putting it to work in the economy or lending it on a short-term basis to other banks. In normal times that amount is close to zero. The increase in overnight deposits is reminiscent of what happened in the 2008 financial crisis, when banks also stopped lending to their colleagues and held onto cash.

On Tuesday, the ECB also fell short in its weekly effort to attract enough bank deposits to offset it purchases of government bonds -- more evidence of banks hoarding cash.

Correspondents Anthony Faiola in London and Michael Birnbaum in Berlin and staff writer Howard Schneider contributed to this report.