Euro Crisis Makes Fed Lender of Only Resort

The Federal Reserve, chastised by Congress for lending money to foreign institutions such as the Central Bank of Libya, is once again the lender of last resort for banks around the world it knows little about.

Three years after the collapse of Lehman Brothers Holdings Inc., money-market borrowing rates for dollars are rising, leading the Fed and European Central Bank to make the currency available to Europe’s institutions for as many as three months. U.S. prime money-market funds cut their exposure to euro-zone bank deposits and commercial paper, or short-term IOUs, to $214 billion in August from $391 billion at the end of last year, according to JPMorgan Chase & Co. data.

The failure of regulators worldwide to address European banks’ fragile dependence on short-term funding is “putting the Fed in a really awkward position,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington regulatory research firm whose clients include the biggest U.S. banks. The swaps with Europe “are an extremely advantageous political football” for critics of the Fed, she said.

The extended funding comes as the U.S. central bank is already under fire for its unprecedented monetary stimulus. Republican leaders including Representative John Boehner of Ohio and Senator Mitch McConnell of Kentucky wrote Chairman Ben S. Bernanke and the Board of Governors on Sept. 19, asking them to “resist further extraordinary intervention in the U.S. economy.”

Lawmaker Criticism

Representative Ron Paul, a Texas Republican who wants to abolish the Fed, and Senator Bernard Sanders, a Vermont independent, have criticized its loans to foreign institutions.

“The Fed has made good on most of its investments over the years, but increasing its exposure and that of the U.S. government to foreign banks is a moral-hazard problem,” said Edward Royce of California, the third most-senior Republican on the House Financial Services Committee. “We are effectively incentivizing U.S. money-market funds to continue to finance these banks.”

U.S. regulators also are becoming less patient with what are turning out to be dollar-funding runs against foreign banks. Financial institutions are too dependent on short-term money- market investors that tend “to flee at the first signs of distress,” William C. Dudley, president of the Federal Reserve Bank of New York, said Sept. 23 in a Washington speech. Regulators also lack access to data on foreign institutions operating in the U.S. that would allow them to “make informed judgments about the adequacy of such firms’ capital and liquidity buffers,” he said.

Large Losses

Investors are fleeing because of concern that banks will take large losses if a euro-zone nation such as Greece defaults. Europe’s debt crisis has generated as much as 300 billion euros ($408 billion) in credit risk for the region’s banks, the International Monetary Fund said last week.

Against the euro, the dollar is heading for its biggest monthly advance since November last year as European policy makers fail to contain their region’s sovereign-debt crisis. It was little changed today at $1.3575 at 3:11 p.m. in Tokyo.

The London Interbank Offered Rate at which banks say they can borrow for three months in dollars rose for a 13th day on Sept. 27 to 0.36522 percent from 0.36278 percent the previous day, according to data from the British Bankers’ Association.

ECB Coordination

The ECB said Sept. 15 it will coordinate with the Fed and other central banks to provide three-month dollar loans to banks to ensure they have enough of the currency through the end of the year. The Fed bears no foreign-exchange or credit risk on the swap lines because the Frankfurt-based ECB is its counterparty.

There were $575 million in outstanding swaps with foreign central banks as of Sept. 21, Fed data show. The ECB loaned a similar amount of cash to two euro-area banks earlier this month in seven-day transactions. The first of three ECB three-month dollar-loan offers starts Oct. 12.

The Fed facility provides a critical “ceiling” on funding squeezes that allows investors to avoid panic and distinguish between healthy and troubled banks, said Jerome Schneider, head of the short-term strategies and money-markets desk at Pacific Investment Management Co. in Newport Beach, California.

“What you don’t want to have is liquidity risk become intertwined with solvency risk,” Schneider said. The swap lines are “the foundation right now to provide a backstop.”

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