World central banks urge calm, prepare for more market turmoil in wake of Credit Suisse rescue

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Central banks around the world are urging calm while preparing for further market turmoil following UBS’s takeover of Credit Suisse over the weekend.

The Bank of Canada, U.S. Federal Reserve and four other central banks stepped up efforts to keep U.S. dollars flowing through the financial system on Sunday by enhancing their so-called swap lines. These allow central banks to trade their own currency with one another, giving non-U.S. financial institutions access to U.S. dollars in the event of a sudden liquidity crunch.

In a joint statement on Sunday, the six central banks said these dollar auctions would be available on a daily, rather than weekly, basis – something last done in the early days of the COVID-19 pandemic. The goal is “to ease strains in global funding markets, thereby helping to mitigate the effects of such strains on the supply of credit to households and businesses,” they said.

So far, the emergency demand for U.S. dollars appears to be muted. The Bank of England and the Bank of Japan received zero bids on Monday in their swap line auctions, while the European Central Bank allotted just US$5-million to a single bidder, according to Bloomberg.

The Bank of Canada, while officially part of the swap line system, has never had to use it because Canadian banks typically have direct access to U.S. dollar funding through their operations south of the border.

The Sunday announcement highlights growing concern among officials that the failure of Silicon Valley Bank and the frantic merger of UBS and Credit Suisse could undercut confidence throughout the global financial system. If banks lose trust in one another, the wholesale markets they rely on to fund much of their operations can seize up – something that happened in the 2007-2008 Financial Crisis and again in March 2020 at the outbreak of the COVID-19 crisis.

Central banks played a key role responding to both earlier crises, providing liquid assets to their countries’ banks – including U.S. dollars obtained through swap lines – to help them meet sudden customer withdrawals and to roll over short-term funding when other financial institutions became too scared to transact.

Central bankers have stepped back into this lender-of-last resort role in the past week. After the failure of Silicon Valley Bank, the U.S. Federal Reserve announced a US$25-billion lending facility that will allow regional U.S. banks to swap their non-liquid assets for cash in the event of a bank run. The Fed also lent US$153-billion to banks through its so-called discount window last week, up from less than US$5-billion the preceding week and exceeding levels seen in the 2008 crisis.

Likewise, Switzerland’s central bank offered up to 50 billion Swiss francs ($74-billion) in emergency credit to Credit Suisse last week.

As of last Wednesday, the Bank of Canada has not had to offer any emergency liquidity to Canadian financial institutions, according to the latest data published Friday.

Several top central bankers urged calm on Monday, arguing that the banking system remains sound and their institutions have the tools needed to prevent financial contagion spreading.

“We are monitoring market developments closely and stand ready to respond as necessary to preserve price stability and financial stability in the euro area,” European Central Bank president Christine Lagarde told the European Parliament on Monday.

“The euro area banking sector is resilient, with strong capital and liquidity positions. In any case, the ECB’s policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed,” she said.

Reserve Bank of Australia assistant governor Christopher Kent said that financial market volatility had increased “but markets are still functioning and, most importantly, Australian banks are unquestionably strong.”

“A key point to stress is that the global banking system as a whole remains well capitalised,” Neil Shearing, chief economist at Capital Economics said in a note to clients on Monday. “Likewise, central banks can also take comfort from the fact that new tools that have been put in place over the past few years to provide liquidity to financial institutions are working and can be expanded if needed.”

Nonetheless, Mr. Shearing said that problems in the banking sector could spread to the broader economy if banks get spooked and start pulling back lending.

“With banks likely to tighten lending conditions in response to the events of the past week, it’s possible that a vicious circle develops, in which credit tightens, the real economy deteriorates, and default rates start to rise. The biggest risks lie in economies with overvalued housing markets.”

Alongside financial stability concerns, this is a crucial week for monetary policy. The U.S. Federal Reserve and the Bank of England are scheduled to announce interest rate decisions respectively on Wednesday and Thursday. Central bankers are facing a serious dilemma: do they continue to push interest rates higher to combat high inflation, or slow down monetary policy tightening in the face of a widening financial crisis? Swap markets are pricing in a roughly 50 per cent chance that the Fed holds off raising rates.

The European Central Bank opted to push ahead with a half-point rate hike last week, while announcing that it was “ready to respond as necessary to preserve price stability and financial stability in the euro area.”