On Sunday, six top central banks — the U.S. Federal Reserve, European Central Bank, Bank of England, Bank of Canada, Bank of Japan and Swiss National Bank — announced a "coordinated action" to boost the U.S. dollar liquidity in the global market.
The liquidity enhancement plan is an expansion of an existing program, in which the Fed exchanges dollars for local currencies with other major central banks every week. Instead of weekly, the central banks will conduct the swap daily starting Monday.
This strategy ensures that the other major economies have a sufficient supply of the global reserve currency. These central banks can then provide seven-day low-risk dollar loans to their domestic banks to keep them afloat.
Expected to last until the end of April, the mechanism aims to "ease strains in global funding markets, thereby helping to mitigate the effects of such strains on the supply of credit to households and businesses."
Analysts said the central bank exchange lines were relatively normal after the pandemic, with foreign central banks holding outstanding exchanges of $472 million against the Fed as of March 15. At the beginning of the pandemic, these central banks held up to $446 billion in outstanding exchanges.
However, the recent issue in the banking sector in the U.S. and Europe has raised concerns about a possible contraction in credit. The issue can make the public avoid banks or banks lose faith in each other, leading to reduced exposure to new credits.
In the U.S., the issue started with the sudden collapse of regional lender Silicon Valley Bank (SVB) on March 10, following a liquidity crunch. Financial regulators eventually decided to close New York-based Signature Bank two days later, citing the need to manage "systemic risks."
The implosions of both banks caused the banking sector to crash in the equity market last week. The Fed, backed by the Treasury Department, launched a new lending facility on March 12 to help commercial banks that encountered a similar issue as SVB and Signature.
Although the banking sector in the U.S. recovered after regulators' effort to assure the public that the banking system remained stable, Swiss bank Credit Suisse announced that it also experienced a liquidity crisis, creating uncertainty again in global markets.
The Swiss central bank pledged to provide a $54 billion loan for Credit Suisse to resolve its short-term liquidity issue. However, analysts said the action did little to convince the public about the stability of the banking system.
Later, the Swiss National Bank eventually agreed to the acquisition of Credit Suisse by rival firm UBS at $3.2 billion, significantly lower than the market value. Moreover, the deal also includes a debt write-out of $17 billion. After the acquisition, the combined bank will have $5 trillion of invested assets.
Fed, BoE to hold rate-setting meetings
The Fed and BoE will hold their respective meetings to determine the next interest rate hikes. Analysts expect both banks to hike interest rates by a quarter of a percentage point, respectively.
However, LH Meyer economist Derek Tang pointed out that the recent joint action by central banks showed that officials had "greater worry" about the possibility of contagion effects. Tang even said it could make the Fed consider not hiking the rate at all.
"To announce joint action so decisively provides a sense of security but also reveals enough anxiety on their part that they feel the need for more insurance against bad outcomes," Tang added.
Analysts explained that central banks' monetary tightening had partially caused the recent crisis in the banking sector. The efforts to tame inflation caused large amounts of withdrawals in consumer banks and led to a shortage in liquidity, with midsized lenders being significantly more affected.
The high interest rates also caused SVB's last capital-raising effort to fail since the value of its assets dropped sharply, making it impossible for the bank to meet its liquidity needs.