Boston Fed President Explains Threat To Credit System

This is a link to a slideshow used by the President of the Boston Fed to a group in Stockholm. The focus of his presentation is on the dependency of international banks on wholesale dollar funding from money market mutual funds. Lehman Brother's failed in the US because of a similar problem. Banks use short term borrowing to invest in longer term assets that provide higher interest rates. They "borrow" from depositors who make deposits in return for low interest rates, and they also borrow from wholesale lenders who provide short term loans that are supported by safe assets that are used as collateral. Money market mutual funds have been the major source of wholesale lending just as they were to Lehman. They stopped lending to Lehman when they lost confidence in the assets that Lehman was putting up as collateral. Consequently, Lehman faced a liquidity crunch since its business model required it to constantly turn over their short term loans as they matured. International banks have been using sovereign debt assets, which had been rated AAA, as collateral for wholesale funding from money market funds. This source of credit has decreased as the funds have lost confidence in the safety of the collateral. The Fed has attempted to provide dollar funding to international banks but it has not been able to fill the funding gap.

This problem illustrates the role of the wholesale funding mechanism in the banking system, and it remains a threat to the safety of the financial system. Banks use these funds and leverage them to provide credit and increase profits. When wholesale lending sources dry up it has the same affect as a run on the banks.