U.S. Federal Reserve Steps Up to Buoy Global Financial Markets

Worried about the continuing threat the European debt crisis poses to the global economy, the U.S. Federal Reserve stepped up Thursday, joining other central banks in an effort to boost dollar liquidity at European financial firms.

The European Central Bank will be the main recipient of the Fed’s dollars, in turn extending dollar loans to banks in nations using the euro zone’s common currency. Many European banks do significant business in dollars, but have been finding it increasingly more difficult to raise dollars from anxious investors.

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Central banks in Britain, Switzerland, and Japan will also contribute to the initiative, which entails swapping dollars for foreign currencies. The move is part of an arrangement with the Fed put in place four years ago, at the outset of the global financial crisis, in order to prevent bank lending from freezing up and endangering too-big-to-fail banks from collapsing the way Lehman Brothers did in 2008.

Europe’s banks hold hundreds of billions of dollars in risky government bonds issued by countries like Greece and Portugal that are now facing default, which could leave banks with massive losses. The banks’ exposure to the debt problems of European nations has made investors more wary of lending them money.The Fed will make short-term dollar loans through “swap lines”, swapping dollars for the equivalent amount in euros, British pounds, Swiss francs, and Japanese yen. The European Central Bank will make those dollars available to euro-zone banks, the Bank of England will make its dollars available to British banks, and so on, all in the form of three-month loans with a fixed interest rate.

The loans will not ease any losses the banks may suffer if any of the countries in which they have invested should go into default, but it will prevent temporary cash shortages from further weakening the banks. The move comes just in time for banks, which toward the end of the year, as they prepare to publicly report their financial positions, tend to shift into cash and away from riskier investments. But this year, cheap dollars have been increasingly hard to come by.

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In the past, European banks have raised dollars by borrowing from U.S. money market funds, but they have been holding back this year. So now U.S. officials are stepping in at no real risk to themselves, as the ECB has guaranteed that the Fed will not lose any money in the transactions. In 2008, the Fed similarly provided dollars to European banks via swap lines on several occasions. Though it received little public attention in the U.S., ECB President Jean-Claude Trichet has credit the swap lines as helping to avoid a much deeper crisis in the world banking system. Those swap lines have remained open since then, but this is the first time the ECB has really taken advantage of them.