Dollar Demand Is Strong, but Lending Lags Behind

By CARRICK MOLLENKAMP

The dollar remains in heavy demand from banks around the world, a sign trust among banks remains fragile.

While a number of indicators show credit markets are thawing, economists, central bankers and investors are paying keen attention to the rate at which foreign banks are pulling dollar deposits out of their U.S. branches. That pace has set records for several months, according to the latest data from the Treasury Department. The moves, analysts say, suggest banks still are scrambling for ways to finance investments in dollar-denominated securities such as U.S. mortgage-backed bonds.

Before the credit crisis hit in August 2007, foreign banks could freely borrow dollars from U.S. banks and one another. Bank affiliates also could sell short-term IOUs. Now banks are demanding bigger lending premiums for certain loans.

On the bright side, the banks' increased reliance on U.S. deposits is making them less dependent on central-bank lending programs, which were put in place as an emergency backstop. Still, it also demonstrates how brittle the lending markets remain. Until banks develop more trust among one another, even short-term borrowing rates will remain relatively expensive, making economic recovery more costly for businesses and individuals.

This has had an unexpected effect on the London Interbank Offered Rate, or Libor, which is supposed to reflect the interest rates banks charge each other for loans. A large gap has appeared between the one-month and three-month Libor, in what analysts say is a worrying sign that banks remain reluctant to make longer-term loans to one another. As of Friday, three-month dollar Libor was 1.01%, 0.59 percentage point more than the rate on one-month loans. Historically the gap hovered close to zero.

The Federal Reserve has been providing dollar loans to the European Central Bank, the Bank of England and other central banks, which lend those dollars to banks around the world. In one sign central bankers' efforts have been working, Libor has fallen sharply: As of Friday, one-month dollar Libor stood at a little more than 0.41%, compared with 4.59% in October.

With short-term lending among banks still tight, non-U.S. banks are seeking other ways to satisfy their hunger for dollars. According to the latest data available from the Treasury, they pulled $123 billion from their U.S. branches in January and another $145 billion in February through borrowings. That is a sharp turnaround from prior months.

As of the end of 2008, banks outside the U.S. held $9.6 trillion in dollar-denominated assets, in a legacy of the heady financial globalization of the boom years, according to the Bank for International Settlements. Amid the financial crisis, U.S. banks stopped lending foreign banks the dollars they needed to finance those investments, triggering an acute cash shortage.

Analysts at Morgan Stanley say foreign banks are tapping deposits in their U.S. branches because it is cheaper than borrowing dollars from central banks. The amount of the Fed's outstanding dollar loans to other central banks, for example, fell in January and February by roughly the same amount that foreign banks pulled out of their U.S. branches.

The shift also could be a reflection of ratings downgrades on the assets that banks use as collateral for central-bank loans, which would make it more difficult and expensive to use central-bank financing.

In a report in March, Scott Peng, a U.S. interest-rate analyst at Citigroup Inc., said the continuing gap between one-month and three-month Libor could be costly for banks. That is because the rates they pay on deposits and other borrowings are typically linked to three-month Libor. The interest income received from loans and other investments often is pegged to one-month Libor. Mr. Peng said the gap could prompt banks to charge higher rates on loans.