To help prevent strains in dollar funding markets from intensifying and spreading, and hence creating more widespread pressure on financial markets, the Federal Reserve established liquidity swap arrangements with the Bank of Canada, the Bank of England, the European Central Bank, the Swiss National Bank and the Bank of Japan. These arrangements provide foreign central banks with the capacity to deliver US dollar funding to institutions in their jurisdictions. The credit is extended by the foreign central bank against the collateral that each accepts, and the interest generated from those transactions is returned to the Federal Reserve. From the perspective of the Federal Reserve, the liquidity swap arrangements are safe. After all, the Federal Reserve is extending credit to the foreign central bank and not to the financial institutions that obtain dollar funding. The credit we extend to the foreign central bank is collateralized by foreign currency deposited with the Federal Reserve. Moreover, the operations do not involve any exchange rate risk for the Federal Reserve, because the swap transactions are unwound at the same exchange rate at which they are established. There is currently only a very small amount of outstanding credit extended through the liquidity swap arrangements, in contrast to the dramatic usage that was observed during the financial crisis. The reason is that the circumstances surrounding the recent establishment of the swap lines differed from those in the middle of the financial crisis. During that earlier period, the need for dollar funding was more severe, and funding markets had become completely dysfunctional.

Both of these programs provide important insights into the role of the central bank as a provider of liquidity, leading to a few observations and to a few questions that I believe warrant further exploration in considering future policy actions. 1 Liquidity swaps with foreign central banks The second half of 2009 and the early part of 2010 were marked by substantial improvements in financial markets, ranging from short-term funding to longer term risk assets. There was good reason for those improvements: Efforts by the government to stabilize markets and support financial institutions were successful, and a virtuous circle appeared to be under way in which increasing optimism about the economic outlook and improving conditions in financial markets fed upon one another. The gains in asset prices were dramatic, with broad equity indexes reversing most of the declines experienced in late2008 and early 2009 and with some measures of short-term funding spreads returning to pre-crisis levels. However, more recent developments have demonstrated that conditions in financial markets can change abruptly. These developments have been widely discussed at this point, and I will not go through them in detail, except to highlight the two broad themes in play. First, investors have become concerned about the fiscal positions of some European countries, leading them to re-price sovereign risk for those countries and to question whether austerity measures and other supporting efforts will prove sufficient to restore market confidence.