The illuminated euro sign is seen in front of the headquarters of the European Central Bank (ECB) in Frankfurt in this April 5, 2011 file photograph.KAI PFAFFENBACH
Central banks have moved to stop the rot. The U.S. Federal Reserve and four other major central banks have decided to dish out three-months' dollar liquidity in a move mostly aimed at relieving the funding tensions of euro zone banks. This has only happened twice before - in October 2008, after the fall of Lehman Brothers, and in May 2010, after the first Greek bailout. The European Central Bank, Bank of England, Swiss National Bank and Bank of Japan will now provide unlimited dollar funds to banks for three months, in three slugs.
European banks, whose shares soared in response, will breathe a sigh of relief. French lenders especially have suffered a chronic funding squeeze since the euro zone crisis spread to Italy in July. With U.S. money market funds shortening the money they extend, they have been forced to swap euros for dollars in currency markets. The price of doing this soared to 115 basis points on Sept. 12, the highest rates since Lehman.
The new facility will give certainty. The ECB already had the ability to lend dollars for one week, but the combination of stigma, and a penal cost of 106 basis points, meant that it has only been used twice in the current crisis - one bank tapped it for $500 million in August, and two lenders took out $575 million last week.
The ECB has not disclosed what rate banks will pay for loans. In previous instances it has charged 100 basis points more than overnight rates for its three-month loans. If the same rate applied now, it would cost banks around 1.07 percent in annualised terms. That's one basis point more than one-week money, and only 17 bps more than it would cost to swap euros for dollars in the market.
The obvious danger is moral hazard - the banks could take the cheap money and lose the impetus to restructure their business. Ideally, the ECB should pressure the banks to restructure their funding profiles.
The other problem is that the new facility delays the bank funding crisis but doesn't solve it. Euro zone banks are also trying to persuade investors to buy their longer-term unsecured debt at affordable rates. This is an uphill struggle in the context of the sovereign debt crisis, and with current plans to make lenders share losses if a bank fails. Jitters will persist until regulators sort this out.