The decision of the Federal Reserve, European Central Bank and other four major central banks to take coordinated measures in order to prevent a shortage of liquidity in the global financial system, including reducing the cost of emergency funding dollars to European banks surprised financial markets, which reacted positively. The action shows how desperate are the authorities to reduce tensions in financial markets that make it difficult for some banks to operate under normal conditions, threatening to spread into the world economy.
The action consists mainly in reducing the costs of ECB funds in U.S. dollars drawn from the Fed, money to provide cheap financing for European banks. Participation of central banks from Canada, UK, Japan and Switzerland is only part of the strategy to demonstrate that major central banks around the world cooperate to prevent a credit crisis in Europe, announced CNBC. “We are witnessing a spurt of the crisis that began several years ago, but now the source of concerns is not the exposure of the banks to toxic assets, but the exposure to sovereign debt. There are also concerns about the collapse of the euro area”, said John Higgins, an analyst at Capital Economics.
Many European banks borrow money in dollars, in part because U.S. interest rates are very low. Usually these loans are financed with loans from other financial institutions. When European banks borrow money in US Dollars or buy assets denominated in dollars, they borrow money from other banks that have available funds in dollars, the American television station explains. Credit institutions can then borrow in local currency and then can use currency swaps to protect themselves from currency risks.
With the euro zone debt crisis intensifying, it became very difficult for many European banks, even impossible, to borrow dollars from other credit institutions. To obtain such funds, banks must turn to the ECB. Another problem is that the price of currency swaps increased, making borrowing in dollars more expensive and encourages the sale of euros, therefore, it puts pressure on the euro and credit is restricted in Europe. Avoiding the problems of financing for European banks is important for the U.S. because these banks are major lenders on the U.S. corporate market. When credit institutions can not fund in dollars American companies, the credit market goes down in the U.S.