To achieve financial stability domestically and maintain the flow of credit to American households and businesses, we took action. Importantly, we developed swap facilities with central banks in countries that represented major financial markets or trading centers in order to facilitate the provision of dollar liquidity to these markets.

We did so in recognition of the scope of dollar markets and dollar-denominated transactions outside of our country, the benefits they provide to U.S. households and firms, and the adverse consequences to our financial markets if these centers lose access to dollar liquidity. We have continued to maintain swap facilities with a number of central banks. Although usage is currently very low, these facilities represent an important backstop in the event of a resurgence in global financial tensions.

[Our] analysis underscores that the Federal Reserve's temporary dollar liquidity swap lines with the European Central Bank and other central banks are an effective response to stresses in dollar funding markets. Last week, the FOMC approved the extension of these swap lines through February 1, 2014. These lines have helped avert fire sales of dollar assets and maintain the flow of credit to U.S. households and firms.

While difficult work still lies ahead, countries in the euro area have made meaningful progress toward achieving long- term fiscal sustainability.

I do not anticipate further efforts by the Federal Reserve to address the potential spillover effects of Europe on the United States.”

In your fourth question, you also asked why the Federal Reserve lent to the central banks of South Korea and Mexico. The Federal Reserve did not extend credit to the central banks of South Korea or Mexico. The Federal Reserve established temporary central bank liquidity swap lines with a number of foreign central banks. Foreign central banks then drew on those lines to provide dollar liquidity to institutions in their jurisdictions. As part of that program, the Federal Reserve swapped U.S. dollars with the central banks of South Korea and Mexico for an equivalent amount of foreign currency at market rates.

Swap lines played an important role in stabilising global dollar funding markets during the economic crisis.

It was very important, as it is important in the current instance, to be clear that we are not taking any fiscal risks. Swaps involve no credit risk because they are between central banks and not between central banks and other parties. They involve no exchange rate or interest rate risk because the interest rate is set in advance and the exchange rate is set in advance.

The liquidity lines, which were authorized by a unanimous vote of the Federal Open Market Committee, are structured similarly to those that were put in place during the financial crisis. As you know, central bank swap transactions have a long and well-established history, and their use by the Federal Reserve and other central banks goes back to the Bretton Woods era of fixed exchange rates. In their current vintage, they are used by foreign central banks to relieve or forestall temporary liquidity pressures in their local dollar funding markets. Foreign central banks draw on these lines by selling foreign currency to the Federal Reserve in exchange for dollars. The foreign central banks then lend these dollars to financial institutions in their jurisdictions. At maturity, the foreign central bank returns the dollars back to the Federal Reserve in exchange for its own currency at the same exchange rate that prevailed at the time of the initial draw, and pays interest as well.

The loans provided by the foreign central banks to institutions abroad are offered at rates that would be above market rates in normal times. As such, when market conditions are not greatly strained, demand for dollar liquidity through the swap lines should not be high, as market alternatives would be more attractive. Likely for that reason, the dollar liquidity offerings by foreign central banks to date have elicited only a modest demand.³ However, even in such instances, the existence of these facilities can reassure market participants that funds will be available in case of need, and thus help forestall hoarding of liquidity, a feature that exacerbated stresses during the global financial crisis.

When the crisis was at its peak in the fall of 2008 and the first part of 2009, those [dollar currency] swap lines were heavily used across the countries...  But even though we've reopened the swap lines, it remains to be seen whether those swap lines will be used as much as before.

Because interbank markets are global in scope, the Federal Reserve has also approved bilateral currency swap agreements with 14 foreign central banks.  The swap facilities have allowed these central banks to acquire dollars from the Federal Reserve to lend to banks in their jurisdictions, which has served to ease conditions in dollar funding markets globally.  In most cases, the provision of this dollar liquidity abroad was conducted in tight coordination with the Federal Reserve's own funding auctions. 

Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm.  The Federal Reserve has never suffered any losses in the course of its normal lending to banks and, now, to primary dealers.  In the case of currency swaps, the foreign central banks are responsible for repayment, not the financial institutions that ultimately receive the funds; moreover, as further security, the Federal Reserve receives an equivalent amount of foreign currency in exchange for the dollars it provides to foreign central banks.

Our lending to other major central banks, who in turn re-lend dollar funding to banks in their own jurisdiction.  As I have mentioned before, that has created liquidity provision around the world that has made the Federal Reserve in some sense the lender of last resort for dollar markets around the world.  That’s important because we have a globalized financial system. If dollar markets are disrupted in the U.K. or in Europe or in Asia, that will have effects on our markets here in the United States.  

…

I guess I would also emphasize – some people have worried about the credit issues. As I mentioned in my remarks, all of those programs are very safe from a credit perspective. The loans to banks and dealers are over-collateralized and with recourse to the firms. The loans to central banks are collateralized with currency of the foreign country and the good faith and credit of those central banks.  The loans in our credit markets are also well-protected and well-collateralized.  So we’re not putting money at risk – in fact, we expect probably to make some money in this – but the purpose of this is to put cash out in order to get this markets working, functioning better – getting credit flowing more freely to help the economy recover.

From the audience Q&A

Indeed, a significant feature of the recent financial market stress is the strong demand for dollar funding not only in the United States, but also abroad. Many financial institutions outside the United States, especially in Europe, had substantially increased their dollar investments in recent years, including loans to nonbanks and purchases of asset-backed securities issued by U.S. residents.¹ Also, the continued prominent role of the dollar in international trade, foreign direct investment, and financial transactions contributes to dollar funding needs abroad. While some financial institutions outside the United States have relied on dollars acquired through their U.S. affiliates, many others relied on interbank and other wholesale markets to obtain dollars. As such, the recent sharp deterioration in conditions in funding markets left some participants outside the United States without adequate access to short-term dollar financing.

The emergence of dollar funding shortages around the globe has required a more internationally coordinated approach among central banks to the lender-of-last-resort function. The principal tool we have used is the currency swap line, which allows each collaborating central bank to draw down balances denominated in its foreign partner’s currency. The Federal Reserve has now established temporary swap lines with more than a dozen other central banks.² Many of these central banks have drawn on these lines and, using a variety of methods and facilities, have allocated these funds to meet the needs of institutions within their borders.³ Although funding needs during the current turmoil have been the most pronounced for dollars, they have arisen for other currencies as well. For example, the ECB has set up swap lines and repo facilities with the central banks of Denmark and Hungary to provide euro liquidity in those countries. The terms of many swap agreements have been adjusted with the changing needs for liquidity: The sizes of the swaps have increased, the types of collateral accepted by these central banks from financial institutions in their economies have been expanded, and the maturities at which these funds have been made available have been tailored to meeting the prevailing needs. Notably, in mid-October, the Federal Reserve eliminated limits on the sizes of its swap lines with the ECB, the Bank of England, the SNB, and the Bank of Japan so as to accommodate demands for U.S. dollar funding of any scale. Taken together, these actions have helped improve the distribution of liquidity around the globe.

This collaborative approach to the injection of liquidity reflects more than the global, multi-currency nature of funding difficulties. It also reflects the importance of relationships between central banks and the institutions they serve. Under swap agreements, the responsibility for allocating foreign-currency liquidity within a jurisdiction lies with the domestic central bank. This arrangement makes use of the fact that the domestic central bank is best positioned to understand the mechanics and special features of its own country’s financial and payments systems and, because of its existing relationships with domestic financial institutions, can best assess the strength of each institution and its needs for foreign-currency liquidity. The domestic central bank is also typically best informed about the quality of the collateral offered by potential borrowers.

Also, to try to mitigate dollar funding pressures worldwide, we have greatly expanded reciprocal currency arrangements (so-called swap agreements) with other central banks. Indeed, this week we agreed to extend unlimited dollar funding to the European Central Bank, the Bank of England, the Bank of Japan, and the Swiss National Bank. These agreements enable foreign central banks to provide dollars to financial institutions in their jurisdictions, which helps improve the functioning of dollar funding markets globally and relieve pressures on U.S. funding markets. It bears noting that these arrangements carry no risk to the U.S. taxpayer, as our loans are to the foreign central banks themselves, who take responsibility for the extension of dollar credit within their jurisdictions.

Another instrument of liquidity provision that central banks are examining is currency swaps to facilitate granting liquidity in other currencies. The central banks found currency swaps useful because the impediments to intermediation in money markets naturally extended to transactions across currencies as well as across maturities and counterparties. Supplying credit in dollars to banks in the euro area and Switzerland helped relieve pressure on those banks and in our markets. In recent months, the Fed was able to make currency swap arrangements on short notice but our reaction time could be even shorter if we keep such arrangements in place or on standby. Thinking carefully about which circumstances in the future would warrant the activation of such arrangements will be a useful form of contingency planning.