A THAWING in dollar markets for European banks may be making it easier for the US Federal Reserve to fund its balance sheet, which has ballooned to a record of more than $3 trillion.

Cash assets of international banks, which are largely bank reserves held at the Fed, have increased 27 per cent since December, the month policy makers decided to quicken the pace of monthly bond purchases to $85 billion from $40 billion.

The Fed finances the expansion of its portfolio through reserves, and the foreign portion of banks’ cash assets climbed to $881.6 billion for the week ending February 20 from $694.9 billion on December 26, Fed data show.

The increased availability of dollar funding to European institutions reflects greater confidence in the continent’s banking system and in the resolution of its sovereign-debt crisis, according to Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

Foreign banks have aided the Fed in funding its prior two rounds of quantitative easing, and their renewed access to dollar reserves is providing the US central bank with a bigger outlet to fund its third asset- purchase programme without risking distortions, he said.

“Finding that European banks have the ability to absorb more of these reserves is a plus,” Crandall said. That “makes it a lot easier to figure out where that first wave is going to go.”

Foreign-bank cash has more than tripled from $257 billion at the beginning of November 2008, the month the Fed announced its first quantitative-easing programme. The bulk of that cash is reserves held at the Fed, Crandall said, with the majority at the Federal Reserve Bank of New York because most of the international banks’ U.S. units are based in its district.

The central bank’s balance sheet has expanded to $3.09 trillion from $2.08 trillion in the same period, and domestic banks’ cash has climbed 67 per cent to $913.3 billion.

Under QE, policymakers direct the markets desk at the New York Fed to buy securities from primary dealers, or brokers who are authorised to trade directly with the central bank, adding funds to the dealers’ accounts and creating reserves at their clearing banks.

QE causes the amount of reserves in the banking system to swell, taking up room on bank balance sheets because the cash counts as an asset. Reserves would factor into a bank’s leverage ratio — equity capital to assets — and if an institution wanted to maintain that metric, it would need to raise more equity or reduce its assets.

So, eventually, QE risks causing a contraction in bank lending if bank balance sheets become overloaded with reserves, according to Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York. The Fed hasn’t set a limit on the size or duration of its latest asset-purchase programme, which began in September with $40 billion of mortgage-backed bonds a month. In December, policy makers decided to add $45 billion in monthly Treasury buying to their stimulus.

“If you start talking multiyear QE, you are talking about every year creating another trillion dollars of assets the banking system is forced to hold, and after a while it starts to add up,” Feroli said.

Many international financial institutions have been more eager than their domestic counterparts to park excess cash at the Fed because it’s become relatively more attractive since April 1, 2011. That’s when the Federal Deposit Insurance Corp. expanded its fee base to include reserve balances at the central bank. The fee doesn’t apply to many foreign banks because they don’t take deposits in the US.

Bigger profit: The insurance fee cuts into US banks’ net returns from leaving extra reserves at the Fed. The central bank has been paying interest on those deposits at a rate of 25 basis points, or 0.25 per cent, since 2008. The FDIC change gave foreign banks an opportunity to make a bigger profit than US banks could at the Fed.

“The foreign banks, through their US branches, are more efficient at holding reserves than the domestic banks because of the FDIC insurance fees that domestic banks have to pay,” said Alex Roever, head of short-term fixed-income strategy at JPMorgan in Chicago. “There are several large foreign banks that have branches in the US that don’t conduct retail-banking operations; they source money wholesale and some of these are pretty active participants in the repo market.”

While the Fed’s dealings with foreign banks since the crisis have proved politically controversial, the increase in reserves shouldn’t be, Crandall said.

Critics — including Senator Bernard Sanders, a Vermont independent who wrote the legislation in the Dodd-Frank financial-overhaul bill requiring a Government Accountability Office audit — have cited overseas institutions’ use of the Fed’s emergency-lending programmes during the crisis as cause for increased scrutiny of the central bank.

“The Fed’s borrowing money from them,” Crandall said. “It isn’t doing anybody any favours.”

The Fed’s disclosure in the minutes from its December Federal Open Market Committee meeting that central bankers discussed curtailing or halting QE3 this year, coupled with demand from foreign banks for reserves, alleviates concern that the central bank’s stimulus will have an adverse impact on lending, Feroli said.

“So far, the evidence is you’ve got ample capacity for the banking system to shoulder this,” he said.

That unfreezing in funding markets may prove to be a boon to the US central bank.

“Somebody has to hold that excess liquidity created by the Fed’s QE,” said Brian Smedley, a strategist in New York at Bank of America Corp. “From a monetary-policy point of view, it doesn’t really matter who.”—Washington Post/Bloomberg