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Bernanke saved Trichet from ForEx panic?

by JakeS Sat Apr 2nd, 2011 at 08:09:42 AM EST

Mike Norman Economics: Foreign institutions were the biggest borrowers from the Fed during the financial crisis

New disclosures that come out of a recent Freedom of Information Act ruling shows that during the height of the financial crisis the Fed lent billions of dollars to foreign institutions.

The data shows that the Fed's discount window was accessed heavily during the Lehman crisis back in October 2008 and through the spring of last year. Two of the biggest borrowers were the European bank, Dexia SA, which took $26.5 billion in a single day and Depfa, a subsidiary of German Hypo Real Estate Group. They borrowed $24.6 billion.

So basically the US Fed rescued a couple of large European banks from their own stupidity by opening the discount window to them during QE1.

Let's unpack that statement a bit.


  1. The US Fed - a foreign institution which has no responsibility to ensure European financial stability - is doing more to stabilise the European banking system than the ECB, which does have a responsibility to stabilise the European banking system.

  2. At least two major European banks were running dollar carry trades that would have blow up in their faces during the Lehman Panic, if the US Fed had not generously extended rediscount facilities to these banks (which, remember, are not the Fed's problem).

  3. The ECB apparently did nothing to kill these carry trades, nor to accumulate hard currency reserves matching the European banking system's foreign currency liabilities. In other words, had the Fed not rescued our banks from their own stupidity, the ECB would have been unable to prevent a ForEx panic. This despite the fact that the € is probably overvalued (we have balanced foreign trade in the middle of a serious depression, which probably indicates that our structural trade balance is in deficit).

To sum up, the ECB seems to prefer uncontrolled currency panics to controlled devaluation on its own time table.

I can haz a central bankster who understands central banking?

- Jake

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Not quite. The reason Dexia and Depfa had to borrow so much from the Fed was because they were cut off from the US$ interbanking markets (because they were basically bankrupt) and had no other way to roll over their exposure over there. Most of what they had to roll over  was boring lending to municipalities and infrastructure projects (because it is a sad fact of life that US banks don't lend money in the US, it was too boring a business, so most of project finance in the US, for instance, is done by European banks which don't find the job beneath them).

So their need for US$ liquidity was not linked to what blew them up in the first place. And it was not silly for the Fed to help them

I'd add that both institutions actually borrowed even more in emergency mode form the ECB at the same time (to solve the same problem of liquidity but in euros...), so the Fed actions were not done in the place of ECB action, but in addition to them.

In both banks (as in a number of banks) the losses were highly concentrated in a small number of places, and most of the activity was sound. It was not completely silly to try to keep these sound bits from being drowned in a messy bankruptcy, with very real consequences for the "real" economy which these banks were actually (also) financing.

Wind power

by Jerome a Paris (etg@eurotrib.com) on Sat Apr 2nd, 2011 at 08:49:48 AM EST
OK, I'll buy that they weren't carry trading. I'll also buy that what the Fed did made sense from their own national self-interest.

That just doesn't touch upon the real problem, namely that European banks had hard currency liabilities that the ECB would probably have been unable to cover in the event that their foreign engagements turned sour. That's not good. You don't want your banks to have ForEx risk on the liabilities side of their balance sheets that exceeds your hard currency reserves - that's a really good way to get a currency crisis.

(The fact that European banks were allowed to operate in the US without setting up independent subsidiaries governed by US law is also a mistake, but that's the Americans' problem.)

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Apr 2nd, 2011 at 12:11:57 PM EST
[ Parent ]
it's kind of unclear whether the US subsidiary or the main European banks did the borrowing.
by rootless2 on Sat Apr 2nd, 2011 at 01:23:02 PM EST
[ Parent ]
Unless both the European and American branches were independently insolvent, there's no reason that a properly set up American subsidiary should be in a worse position than City on the American interbank market. So either they had been gambling on the American market (contrary to the theory that their main activity had been in municipal bonds and project finance that the Fed wanted to save), or they had insufficiently credible separation between the balance sheets of mother and daughter company.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Apr 2nd, 2011 at 04:04:10 PM EST
[ Parent ]
Wholesale banking is often done by branches of foreign entities, not by subsidiaries. As only retail banking is expected to have deposit insurance, it is considered necessary that foreign retail banking operations be subsidiaries, whereas wholesale banking can be carried out by branches.


Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Sat Apr 2nd, 2011 at 06:31:13 PM EST
[ Parent ]
European banks had hard currency liabilities that the ECB would probably have been unable to cover in the event that their foreign engagements turned sour.

I keep saying that a monetary authority needs to accumulate reserves, as a matter of policy, in an amount at least equal to the aggregare foreign liabilities of its domestic economy, in order to be able to operate as a lender of last resort. This has the advantage that it introduces a negative feedback loop on carry trades.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Sat Apr 2nd, 2011 at 06:29:14 PM EST
[ Parent ]
I can sort of see that this might be the case, but I would appreciate some clarification and examples.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sat Apr 2nd, 2011 at 08:13:47 PM EST
[ Parent ]
If your banking system has liabilities in hard currency that it is not able to meet, it will attempt to obtain said hard currency on the open market. This will cause an uncontrolled depreciation of your currency. Further, it is difficult to predict the magnitude of this depreciation, since it depends heavily on the short-run price elasticity of the foreign demand for your currency. Which you don't know and can't measure ahead of time.

Potentially you can end up in a situation where the ForEx market fails to clear, and your currency goes through the floor. Then you have to go to the IMF for liquidity support, and then the crisis gets turned into a catastrophe, because turning crises into catastrophes is what the IMF does for a living.

Now, if your central bank keeps tabs on all private bank hard currency liabilities and makes sure to buy foreign currency to match (with freshly printed money, which it can always do), you achieve two things: First, since your central bank is able to cover your private banks' hard currency liabilities, it can decisively check a run on your currency. Second, in the process of accumulating ForEx reserves, it causes your currency to depreciate. And since the real interest rate for private banks on foreign loans is [nominal interest rate - foreign inflation + rate of depreciation of domestic currency against foreign currency], you force up the real interest rate the banks have to pay to borrow hard currency. So you limit the impact on the exchange rate both by spreading the hard currency purchases over a longer time period and by reducing the total volume of hard currency liabilities in your banking system.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Apr 2nd, 2011 at 11:19:02 PM EST
[ Parent ]
And since the real interest rate for private banks on foreign loans is [nominal interest rate - foreign inflation + rate of depreciation of domestic currency against foreign currency], you force up the real interest rate the banks have to pay to borrow hard currency. So you limit the impact on the exchange rate both by spreading the hard currency purchases over a longer time period and by reducing the total volume of hard currency liabilities in your banking system.

This must be well understood by central bankers, so the extent to which they fail to do this should be a measure of the extent to which they are susceptible to pressures from the banks to act in some combination of the banks' and the domestic economy's short term interests rather than performing their formal duties of acting to protect the integrity of the currency and the banking system -- a measure, if you will, of central bank independence and integrity.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Sun Apr 3rd, 2011 at 07:25:47 AM EST
[ Parent ]
This should be well understood but likely isn't.

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Sun Apr 3rd, 2011 at 07:53:45 AM EST
[ Parent ]
Well, if you tell them the quoted paragraph, then they would presumably agree. However, they would likely think that it's a solution to a non-existing problem.

I'll highlight the bits central bankers would probably object to in my description of the problem:

If your banking system has liabilities in hard currency that it is not able to meet, it will attempt to obtain said hard currency on the open market. This will cause an uncontrolled depreciation of your currency. Further, it is difficult to predict the magnitude of this depreciation, since it depends heavily on the short-run price elasticity of the foreign demand for your currency. Which you don't know and can't measure ahead of time.

Potentially you can end up in a situation where the ForEx market fails to clear, and your currency goes through the floor. Then you have to go to the IMF for liquidity support, and then the crisis gets turned into a catastrophe, because turning crises into catastrophes is what the IMF does for a living.

  • Serious central banksters do not believe that banks will ever be systemically unable to meet their foreign obligations: The Market is Magic, so the only possible problem in their world i idiosyncratic insolvency and systemic illiquidity.

  • Serious central banksters do not believe that uncontrolled currency depreciations are possible for Serious and Responsible currencies, because they believe that they can check a currency crash by raising interest rates to induce foreign speculators to buy domestic currency. The fact that this chokes your domestic economy, thus making it less attractive for real investment, is not the central bank's problem. At least not until the hot speculative money wises up to the fact that you can't continue paying that high interest rate...

  • The very concept of a market that fails to clear makes heads explode among self-respecting economists, including Serious central banksters.

  • Serious central banksters believe in the benevolence of the IMF.

Further, the solution carries non-trivial costs: You have to accept a currency depreciation. Which is both a real problem, in that you cede part of your currency policy to the private sector, and a mental block problem for the inflation-neurotic monetary chickenhawks usually appointed as central banksters. So since the solution comes with a non-trivial cost, and the central banksters are in denial about the existence of the problem, the Serious and Responsible thing to do is to not implement it.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun Apr 3rd, 2011 at 09:44:58 AM EST
[ Parent ]
is that right about project loans? When we were looking for project financing about 5 years ago, we found it available easily in Singapore but not in the US at all. I thought it was just us.
by rootless2 on Sat Apr 2nd, 2011 at 01:04:10 PM EST
[ Parent ]
There is nothing wrong with a foreign bank accessing the discount window. Let's remember that the discount window is overcollateralised lending - Dexia and Depfa were posting collateral in excess of the loan value, and the loans were short-term and rolled over periodically as long as the collateral stayed eligible.

There's going to be a lot of gnashing of teeth about the Fed loaning out taxpayer dollars to foreign institutions, which is a totally wrongheaded thing to gnash teeth about.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Sat Apr 2nd, 2011 at 06:34:32 PM EST
Indeed. The problem isn't that the Fed acted as lender of last resort for the domestic American banking system. The problem is that the ECB didn't seem to be able to act as lender of last resort for European banks.

Incidentally, I am not quite sanguine about wholesale banking being done without setting up proper subsidiaries with reasonable tight separation between mother and daughter balance sheets. It seems to me that there are possibilities for both contagion and various forms of aggressive accounting (the art form formerly known as "fraud") in such a setup.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Apr 2nd, 2011 at 07:02:24 PM EST
[ Parent ]
ECB might have avoided to look like it was dumping treasuries. Someone shouting "ECB dumps treasuries" might have caused interesting reactions.
by Jute on Mon Apr 4th, 2011 at 02:33:53 PM EST
[ Parent ]


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