Solvency can wait, for now deal with liquidity

CENTRAL banks are once again coming to the financial system’s rescue. In a move coordinated with its counterparts in America, Japan, Switzerland and Britain, the European Central Bank today announced it would make special, three-month dollar loans to euro-zone banks to cover funding needs over the year-end.This has delivered a shot in the arm to European stock markets, and bank stocks in particular. European banks regularly borrow in dollars to make dollar loans and finance dollar-denominated inventory. But concerns about the banks’ solvency should their holdings of peripheral sovereign debt sour have prompted the American money market funds and others who lend to the banks to pull back. European banks have lost access to $700 billion in dollar funding in the last year, according to this excellent analysis in today’s Wall Street Journal.Today’s operation is a bandage, not a cure. The liquidity problems in Europe’s banks are rooted in fears of insolvency. Putting those fears to rest will require aggressive recapitalisation so that the banks can withstand plausible scenarios of European sovereign default. And of course, that means Europe must also accept the inevitability of such default while ring-fencing fundamentally sound countries like Italy and Spain. (Read the extensive coverage in this week’s issue, available online today.)That said, liquidity crises can beget solvency crises. Fundamentally sound banks denied access to dollar liquidity will be forced to cut off lending and perhaps dump assets at fire-sale prices, impairing the value of everyone’s assets and starving borrowers, including those in America, of credit.The lessons of America’s 2008 financial crisis is that the Fed’s ample provision of liquidity mitigated but did not resolve the crisis, since illiquidity was rooted in market players’ inability to figure out who was solvent. Ending the crisis once and for all required the promise of government-backed recapitalisation via first the TARP, then the stress tests, to ensure that the banks were, fundamentally, solvent.Why is the Fed involved in today’s operation? Like any good lender-of-last resort, the ECB can lend unlimited amounts of its own currency (euros) to its banks simply by printing it. However, the ECB can’t print dollars, so it borrows them from the Fed which, of course, has an unlimited supply. Since printing dollars infringes on monetary policy, the Federal Open Market Committee had to approve these so-called swap lines a year ago (the announcement is here). They were renewed last January, to run through August 2012. At present, there are no loans outstanding under the swaps. The Fed didn’t issue a press release today since everything the ECB is doing is permitted under the current swap agreements, although naturally they consulted with each other. (The ECB had already been offering seven-day loans in dollars.)The Swiss National Bank and the Bank of England are making similar dollar loans available to their banks under their own swap agreements with the Fed, although one suspects they are doing so more out of solidarity than necessity: when politicians are at each others’ throats, it’s nice to know the central bankers can still get along.An interesting question is whether these operations expose the Fed to more political blowback. Republican presidential candidates have been taking potshots at the Fed, principally over its quantitative easing, and it wasn’t that long ago that congressmen of both parties were attacking swaps as a bailout of undeserving foreigners. With a very modest amount of reflection they should realize that keeping dollars flowing through global banks is ultimately in the interest of our own banking system. We’ll see.