Equity markets cheered the move by five central banks led by the US Federal Reserve (Fed) to lower borrowing costs in US Dollars (USD) for European banks. Equity indices rallied by over 3% across the globe on the back of the central banks action. The central banks of US, Japan, Canada, UK, Switzerland and Eurozone lowered the premium over the overnight swap rates from 100bps to 50bps to help ease pressure on USD liquidity for banks in Europe.
Why did the rise in cost of funding for European banks become important to the Fed?
The rise in bond yields in debt ridden countries of Europe cast doubts on the balance sheets of European banks. The sharp rise in borrowing costs for Italy, which had to pay over 7% for its borrowing (up by 250bps over the last four months) led to worries of sustainability of Italy’s debt (at 120% of GDP and absolute value of USD 2.2 trillion) and European banks hold a large amount of Italy’s debt (over 40%).
High exposure to Italy and other debt ridden nations debt prompted rating agencies to cut credit ratings of European and US banks. Given the lowered credit rating, the lenders of USD to European banks started demanding higher yields for lending to the banks. The 3month Euro basis swap rate moved down from negative 80bps to negative 150bps for European banks, indicating that the cost of borrowing almost doubled. European banks would have faced a huge USD liquidity crunch if the basis swap rate moved down further.
Lack of USD liquidity for European banks could have led to default scenarios where banks default on USD loans given the lack of availability of USD. Defaults by European banks would have led to contagion risk that could have stopped the interbank market from functioning. A non functioning interbank market had led to the collapse of markets in 2008 and the Fed did not want such an event to occur again.