This Day On The Street
Continue to site
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Central Banks to the Rescue? What Today's Action Means




By John Carney, CNBC.com Senior Editor

NEW YORK ( CNBC) -- The attempt by major central banks to ease strains on Europe's credit markets certainly cheered financial markets on Wednesday, but what does the coordinated action actually do?

In essence, the U.S. central bank, or Federal Reserve, agreed to provide cheaper dollar funding to the European Central Bank-- which can then provide cheaper dollar loans to cash-strapped European banks.

The participation of the central banks of Canada, England, Japan and Switzerland is more of an effort to show that all the central bankers are working together than any expectation that there will be lots of dollar borrowings under their facility.

The goal is to ease the credit crunch in Europe. Lots of European banks make dollar denominated loans, in part because U.S. interest rates are so low. The banks do not usually finance these loans in the way you might think -- by lending out the deposits of their retail customers. Instead, the loans are financed by short-term borrowings from other financial institutions.

More from CNBC
Banks React to Central Banking Plan for Europe
The Euro: Flawed From the Start
The Joint Swap Lines Are a Confidence Game

When European banks make a dollar loan or purchase a dollar denominated asset, they typically borrow the dollars on the what's called "international wholesale deposit market" -- which is a fancy word for borrowing from other banks that have dollars. Alternatively, they can borrow in their native currency and then use foreign exchange swaps to hedge the currency risk.

Now that Europe is in the throes of a debt crisis, it has become much more difficult if not impossible for many European banks to borrow dollars in the wholesale markets. To make dollar loans, then, they have to turn to the European Central Bank. What's more, the cost of the foreign exchange swaps has increased, making it more expensive to make dollar loans based on euro assets.

Normally, central banks only make loans in their domestic currencies. But in times of international stress -- the credit crisis of 2008, for instance -- central banks around the world set up swap lines that allow them to borrow from each other, creating the ability for them to make loans in other currencies.

In short, European banks were finding it too expensive to make dollar loans, which hurt their ability to lend dollars and encouraged them to sell euros. This depressed the value of the euro and restricted credit in Europe. The ECB arranged to borrow dollars more cheaply from the Fed, so it could ease this market.

So is this some giant giveaway to profligate Europeans of U.S. taxpayer money?

Not quite. In the first place, European banks are major lenders to the U.S. corporate market. When they cannot participate in dollar loans to U.S. companies, U.S. credit also contracts. What's more, these are loans to the ECB, which is unlikely to default. Finally, the Fed isn't lending out "taxpayer dollars" at all. Rather, it is lending out newly created dollars at very low interest rates.

That doesn't mean that U.S. taxpayers are not at risk here, of course. The new dollars have the potential to spark inflation -- which could result in higher interest rates and higher taxes as the government combats inflation. But in the current economic environment, the risk of inflation is very slight.

-- Written by John Carney, CNBC.com Senior Editor

CNBC is a world leader in business news, providing real-time financial market coverage and business information.

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Submit an article to us!
SYM TRADE IT LAST %CHG
AAPL $128.95 0.00%
FB $78.99 0.00%
GOOG $537.90 0.00%
TSLA $226.03 0.00%
YHOO $42.51 0.00%

Markets

DOW 18,024.06 +183.54 1.03%
S&P 500 2,108.29 +22.78 1.09%
NASDAQ 5,005.3910 +63.9670 1.29%

Partners Compare Online Brokers

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs