The Federal Reserve and the Bank of Japan recently developed a facility that would provide large amounts of dollars to branches of Japanese banks in the United States for the purpose of forestalling a modern-day run on Japanese banks. We regard this as good public policy.
It establishes the facility before a possible crisis. Moveover, by informing the banking system and the public of the facility's existence, the monetary authorities may have successfully assuaged concerns.
The premium over Interbank market rates that Japanese banks have had to pay to attract liabilities has been widening, with reports of the premium rising to as much as 40 basis points for some. Furthermore, the scuttlebutt is that increasing numbers of lenders are cutting back on the amounts they will lend to Japanese banks. Therein lies the problem. While the rising cost of funds eats away at profits, the denial of funds culminates in a modern-day run - the inability of a bank to replace maturing liabilities. As best we can determine, the facility would work this way.
The Federal Reserve would lend dollars to the Bank of Japan. Those loans would be secured by U.S. Treasury securities. The Federal Reserve would probably require an excess of collateral over the loan, perhaps 110%, and would mark the collateral to market daily, calling for additional collateral if the value of the securities fell below the 110% level.
The Bank of Japan would lend the dollars to U.S. branches of Japanese banks that need the funds. The Bank of Japan would have to make its own collateral arrangements. Since the Fed would know exactly how much it was lending, it would presumably sterilize the infused dollars through open market operations.
The amounts could be quite large and could be gotten on short notice. Consequently, there could be a temporary surfeit in the money market for overnight and short-term funds.
But the Fed's basic monetary posture and reserve infusion targets would not be altered or violated. The assertion that this facility is only intended for U.S. branches is, possibly, misleading. International banks now fund internationally. Thus, the U.S. branches of Japanese banks could simply be a conduit for dollar funding of Japanese banks around the world. This facility represents an innovation. It goes beyond the well-established swap facility, which is used for purposes of foreign exchange intervention.
This new facility would represent a creation of credit for the purpose of providing liquidity. The facility is another step in the internationalization of the financial system, whereby central banks recognize the interconnectedness and interdependence of banks and the need to maintain an orderly payments system.
If one or several large Japanese banks were to fail, such failures could trigger a chain reaction that would radiate throughout the financial system and potentially reek havoc on economies, not to mention financial institutions.
The announcement of the establishment of the facility by Congressman Jim Leach, chairman of the House Banking Committee, serves the dual purpose of validating the legality of the facility and disarming the snipers and critics in advance. If the facility does need to be activated, the situation would be delicate, and criticism of the use of the facility at that time could exacerbate the situation.
This new lending facility does not solve the problems of the Japanese banks. It simply ensures a much larger pool of resources in the event that the private sector holds back on its stream of lending to them.
It is a creditable facility, since Japan has enormous reserves and runs a continuing balance of payments surplus. In other words, Japan is a good credit, especially when its borrowings are collateralized by U.S. Treasury securities. Mr. Sherman is director of research at M.A. Schapiro & Co., New York.
