The announcement of co-ordinated central bank action to boost foreign exchange swap lines on Wednesday has boosted market sentiment. The central banks have become extremely alarmed about the deterioration in the funding market for eurozone banks, and the consequent deleveraging of bank balance sheets which this is causing, and have decided to inject a great deal more liquidity into the system to bring this back under control. The injection of additional dollar liquidity which the Fed will undertake through its currency swaps with the ECB could potentially involve a very large increase in the Fed’s balance sheet, so it is worth understanding exactly what this initiative involves.

The genesis of the recent funding problems for eurozone banks has come not from the euro markets, but from the dollar markets. In the boom years, these banks greatly increased their dollar assets (in the form of loans and securitised debt instruments), and funded these activities not by increasing bank deposits, but by short term borrowing in the interbank markets and the money markets. This is a vulnerable position, involving both a liquidity mismatch (long dated assets funded by short dated liabilities), and also the need for cross-border or cross-currency borrowing. In recent weeks, the deterioration in the eurozone debt crisis has undermined confidence in the solvency of eurozone banks, and dollar financing for them has dried up.