Last Resort: European Central Bank's Permanent Engagement in Tackling Foreign Exchange Liquidity Disruptions in the Euro Area Banking System

Abstract

Prior to the outbreak of the global financial crisis, the international interbank market for key currencies narrowed and market participants faced foreign currency liquidity shocks more frequently. The US Federal Reserve was first to address the problem with a series of currency swap lines concluded with other major central banks after December 2007. Although these measures were initially considered temporary, they are still present today in the practices of the leading central banks, and thus of the European Central Bank. Inter central bank currency swap lines facilitate, if necessary, the provision of an adequate level of foreign currency liquidity to the banking system as a kind of “last resort”, on more favourable terms than market conditions. In our study, we examined the evolution of the demand for foreign currency liquidity provided by the European Central Bank to the euro area banking system between 2007 and 2019, on quarterly data and using vector autoregression. We found that the allocation of dollar-denominated foreign currency resources through the ECB’s tenders increases the most when the banking system is unable to raise international funds on a market basis, when dollar market tensions rise or when their return on assets ratios deteriorate.