Central Bank Liquidity Swaps
Two weeks ago, the Federal Reserve took action to expand the capabilities of its liquidity swap lines with other central banks. The Fed lowered the rate that it charges central banks on existing dollar liquidity swap lines, and it extended the authorization of those lines to February 1, 2013. In addition, the Fed reinstated reciprocal swap lines with other central banks, so that operations can be conducted using foreign currencies.
These central bank swap lines were originally put in place at the beginning of the financial crisis in 2007, and since then they have been used periodically. A look back at how they were used during the crisis can help to explain why these recent actions were taken.
For foreign banks, liquidity problems started in 2007 because of the proliferation of dollar-denominated assets in the global banking system. A large chunk of securities, such as the now-infamous mortgage-backed securities (MBS), ended up in the hands of foreign banks, and those banks had funded those assets in short-term, wholesale markets. More simply, the banks were borrowing dollars for periods of less than 3 months to buy these long-term securities. That strategy works when markets are liquid, but by the middle of 2007, that was no longer the case.
With the financial crisis sharply reducing liquidity in financial markets, foreign central banks used the swap lines to borrow large amounts of dollar liquidity in 2008 and 2009. By far, the biggest user was the European Central Bank, whose outstanding amounts peaked in late 2008 at over $300 billion. The Bank of England and the Bank of Japan also were heavy users, topping out at $95 billion and $125 billion, respectively. There were seven other central banks that all conducted operations as well, but they made up a minority of the outstanding balances at any one point in time.
At the very height of the crisis, the swaps were being drawn at shorter tenors. One-day draws peaked in October 2008, spiking up to over $150 billion, and tenors within one week topped $150 billion in early November 2008. The same was true with swap operations that lasted for one month, as they quickly hit their highest point in the last three months of 2008. However, by the first part of 2009, swaps of longer tenors easily started dominating the composition of the outstanding operations. Swaps with tenors of 60 or more days grew to over $360 billion.
Collectively, these programs helped to improve liquidity in the interbank lending market. One way to measure how effective the dollar lending was at easing conditions is to look at the 1-month and 3-month Libor-OIS spreads. The Libor is the London interbank offer rate, a floating rate that fluctuates depending on how risky the borrowers appear to the lenders. The overnight indexed swap (OIS) rate is a more stable rate, and it simply measures the cost of swapping a fixed interest rate for a floating interest rate.
Noticeably, the spreads on the 1-month and 3-month measures widened substantially during the fall of 2007, meaning lenders saw foreign banks as more risky than they had in the past. The spreads spiked from 10 basis points (bp) to 50 bp in a matter of days, putting strains on the balance sheets of foreign banks. Following the collapse of Lehman Brothers in September 2008, both 1-month and 3-month spreads increased from their already elevated levels to crisis peaks.
The interesting observation is that when swap operations began to be used heavily, the spreads fell below their previously elevated levels. Just two months after the surge in shorter-term swaps, the Libor-OIS spreads fell from their peaks to levels much closer to normal. For example, instead of falling to the elevated 50 bp threshold, the 1-month spread tumbled all the way to 30 bp and continued to soften in early 2009. Similarly, the longer-term Libor-OIS spread receded to more normal levels as large amounts of long-term swaps were drawn.
Even though these swaps had expired in February 2010, they were quickly reauthorized in May 2010 after the beginning of the Greek debt crisis. Evidence of the strains caused by this crisis can be seen in the Libor-OIS spreads, which rose to 15 bp and 33 bp in the 1- and 3-month periods, respectively. Helped in part by the swap lines, as liquidity in the interbank funding market improved, the spreads calmed during the summer of 2010.
More recently, with other European countries’ finances under pressure, liquidity in the interbank market has again deteriorated. The 1-month spread recently hit 19 bp, and the 3-month spread is now nearing 50 bp. In response to these conditions, the Fed and other central banks took action to make more liquidity available.
Specifically, the Fed lowered the cost of dollar liquidity to the other central banks. Instead of charging 100 bp over the OIS rate, the Fed is now requiring a spread of 50 bp over OIS. By lowering this rate, the Fed has effectively put a ceiling on the cost of dollar liquidity. Terms for operations conducted using foreign currencies have not yet been determined, but those will be decided upon if U.S. banks start experiencing greater strains in their foreign currency funding.
Already European banks have taken advantage of the extension of dollar liquidity. Last week, the European Central Bank reported that over $50 billion of 84-day swaps were drawn by banks in the euro zone. Although these quantities are very small compared to crisis-level amounts, the swap line actions taken by the Fed and other central banks should help support market liquidity.