Causes of The US Dollar Shortage During The GFC

• The US dollar shortage that was witnessed during the 2008 crisis had many causes. Some of these were –

1. Expansion in banks’ Global Balance Sheets

• The funding difficulties which arose during the crisis are directly linked to the remarkable expansion in banks’ global balance sheets over the past decade.
• Reflecting in part the rapid pace of financial innovation, banks’ (particularly European banks’) foreign positions had surged since 2000, even when scaled by measures of underlying economic activity.
• As banks’ balance sheets grew, so did their appetite for foreign currency assets, notably US dollar-denominated claims on non-bank entities. These assets include retail and corporate lending, loans to hedge funds, and holdings of structured finance products based on US mortgages and other underlying assets.
• During the build-up, the low perceived risk (high ratings) of these instruments appeared to offer attractive return opportunities. During the crisis they became the main source of mark to market losses.

2. Accumulation of US dollar assets

• The accumulation of US dollar assets saddled banks with significant funding requirements, which they scrambled to meet during the crisis, particularly in the weeks following the Lehman bankruptcy.
• To better understand these financing needs, one should break down banks’ assets and liabilities by currency to examine cross-currency funding, or the extent to which banks fund in one currency and invest in another.
• On analysis, it was found that, since 2000, the Japanese and the major European banking systems took on increasingly large net (assets minus liabilities) on-balance sheet positions in foreign currencies, particularly in US dollars.
• While the associated currency exposures were presumably hedged off-balance sheet, the build-up of net foreign currency positions exposed these banks to foreign currency funding risk, or the risk that their funding positions (FX swaps) could not be rolled over.

3. Extensive globalization and cross-currency funding

• By the time of the crisis, banks had become extensively globalized, with offices in many countries around the world. This made it very difficult to identify vulnerabilities in their balance sheet.
• Stresses build up across the global balance sheet, as mismatches in the currency or maturity of assets and liabilities, and thus can be understood only by looking at banks’ worldwide positions consolidated across all office locations.
• In some cases, banks’ cross-border assets booked by offices in a particular host country can account for the bulk of that country’s external asset position, and yet still represent a relatively small part of the consolidated banking systems’ worldwide assets.
• This fact clouds the interpretation of the “national balance sheet” for many host countries, since banks’ long or short currency positions booked in one office location and offset in another may signal a “mismatch” in the host country’s net external position when none may, in fact, exist.
• The main problem around this was that often a large amount of foreign currency (usually dollars) had to flow out of the United States to fund the various positions around the globe. Not only that, the comprehension around the net outflow was not certain due to the complexity of tens of thousands of positions on the balance sheet of a global bank.

Financing Foreign Currency Positions

• Consider a bank that seeks to diversify internationally, or expand its presence in a specific market abroad. This bank will have to finance a particular portfolio of loans and securities, some of which are denominated in foreign currencies (e.g. a German bank’s investment in US dollar-denominated structured finance products). The bank can finance these foreign currency positions in several ways-
  • 1. The bank can borrow domestic currency, and convert it in a straight FX spot transaction to purchase the foreign asset in that currency.
  • 2. It can also use FX swaps to convert its domestic currency liabilities into foreign currency and purchase the foreign assets.
  • 3. Alternatively, the bank can borrow foreign currency, either from the interbank market, from non-bank market participants or from central banks.

Structure of Global Banks’ Operations

• Internationally active banks have offices in many countries around the world. Their currency and maturity positions are managed across the consolidated global entity rather than office by office.

• Thus, large measured “mismatches” on the balance sheet of an office in one location may be hedged off-balance sheet or offset by on-balance sheet positions booked by offices elsewhere, leaving a matched book for the bank as a whole.

• Overall, foreign offices account for a significant share of banks’ worldwide consolidated balance sheets. In most cases, less than half of banks’ foreign claims are booked by their home offices, with French and Japanese banks being exceptions.

• At the extreme are Swiss banks, with more than $3 trillion in foreign claims, accounting for over 80% of their total balance sheet assets. Only 18% of their foreign claims are booked by offices in Switzerland.

Balance Sheet Expansion of Global Banks

• The origins of the US dollar shortage during the crisis are linked to the expansion since 2000 in banks’ international balance sheets. The outstanding stock of banks’ foreign claims grew from $10 trillion at the beginning of 2000 to $34 trillion by end-2007, a significant expansion even when scaled by global economic activity.

• The year-on-year growth in foreign claims approached 30% by mid-2007, up from around 10% in 2001. This acceleration took place during a period of financial innovation, which included the emergence of structured finance, the spread of “universal banking”, which combines commercial and investment banking and proprietary trading activities, and significant growth in the hedge fund industry to which banks offer prime brokerage and other services.

• At the level of individual banking systems, the growth in European banks’ global positions is most noteworthy. For example, Swiss banks’ foreign claims jumped from roughly five times Swiss nominal 𝐺𝐷𝑃 in 2000 to more than seven times in mid-2007. Dutch, French, German and UK banks’ foreign claims expanded considerably as well.

• For European banking systems, their estimated US dollar (and other non-euro) denominated positions accounted for more than half of the overall increase in their foreign assets between end-2000 and mid-2007.

Cross Currency Funding Positions

• To examine cross-currency funding, or the extent to which banks invest in one currency and fund in another, requires a breakdown by currency of banks’ gross foreign positions.

• For some European banking systems, foreign claims are primarily denominated in the home country (or “domestic”) currency, typically representing intra-euro area cross border positions (e.g. Belgian, Dutch, French and German banks).

• For others (e.g. Japanese, Swiss and UK banks), foreign claims are predominantly in foreign currencies, mainly US dollars. Foreign currency assets often exceed the extent of funding in the same currency. This is shown in this figure, where, in each panel, the lines indicate the overall net position (foreign assets minus liabilities) in each of the major currencies.
• Assuming that banks’ on-balance sheet open currency positions are small, these cross-currency net positions are a measure of banks’ reliance on FX swaps. Many banking systems maintain long positions in foreign currencies, where “long” (“short”) denotes a positive (negative) net position. These long foreign currency positions are mirrored in net borrowing in domestic currency from home country residents.

• UK banks, for example, borrowed (net) in sterling (some $550 billion in mid-2007, both cross- border and from UK residents) in order to finance their corresponding long positions in US dollars, euros and other foreign currencies.

• By mid-2007, their long US dollar positions stood at $200 billion, on an estimated $2 trillion in gross US dollar claims. Similarly, German and Swiss banks’ net US dollar books approached $300 billion by mid-2007, while that of Dutch banks surpassed $150 billion.
• Several European banking systems expanded their long US dollar positions significantly since 2000, and funded them primarily by borrowing in their domestic currency from home country residents. This is consistent with European universal banks using their retail banking arms to fund the expansion of investment banking activities, which have a large dollar component and are concentrated in major financial centers.
• In aggregate, European banks’ combined long US dollar positions grew to roughly $700 billion by mid-2007, funded by short positions in sterling, euros and Swiss francs. As banks’ cross currency funding grew, so did their hedging requirements and FX swap transactions, which are subject to funding risk when these contracts have to be rolled over.

Maturity Transformation Across Banks’ Balance Sheets

• Maturity transformation is the practice followed by many financial institutions, wherein, they fund longer term assets using shorter term liabilities and keep rolling over the liability.

• The bank is said to face a foreign currency funding gap if the investment horizon of its foreign currency assets A, exceeds the maturity of its foreign currency funding or FX swaps.

• Interbank claims, which include interbank loans and debt securities claims, tend to be shorter- term or can be realized at shorter notice than claims on non-banks. US dollar claims on non- banks are usually assumed as banks’ desired US dollar investment portfolio. This portfolio of non-bank assets includes banks’ retail and corporate lending, lending to hedge funds, and holdings of securities ranging from US Treasury and agency securities to structured finance products.

• Whether these non-bank assets can be readily converted to cash depends upon the maturity of the underlying positions as well as on their market liquidity.

• These US dollar investments are funded by liabilities to various counterparties. Banks can borrow US dollars directly from the interbank market, typically short-term. They can also raise US dollars via FX swaps (with bank or non-bank counterparties), which are even shorter-term on average.
• In contrast, US dollar funding provided directly by non-banks includes corporate and retail deposits, deposits from central banks, and financing from money market funds, and is thus of varying maturities. Money market funds had become an important source of short-term US dollar financing, providing an estimated $1 trillion to European banks in 2007.

• If the effective maturity of liabilities to non-banks matches that of their investments in non banks (i.e. is “longer-term”), then a lower-bound estimate of their US dollar funding gap is the net US dollar position vis-a-vis non banks.

• If, on the other hand, banks’ liabilities to non-banks were all short-term, then an upper-bound estimate of their funding gap is their gross US dollar position in non-banks.

The US Dollar Shortage & Response of Banks

• Beginning in August 2007, heightened counterparty risk and liquidity concerns compromised short-term interbank funding. The related dislocations in FX swap markets made it even more expensive to obtain US dollars via currency swaps, as European banks’ US dollar funding requirements exceeded other entities’ funding needs in other currencies.

• European banks’ funding difficulties were compounded by instability in the non-banksources offunds as well. Money market funds, facing large redemptions following the failure of Lehman Brothers, withdrew from bank-issued paper, threatening a wholesale run on banks.

• Less abruptly, a portion of the US dollar foreign exchange reserves that central banks had placed with commercial banks was withdrawn during the course of the crisis. In particular, some monetary authorities in emerging markets reportedly withdrew placements in supportoftheir ownbankingsystems in need of US dollars.

• Market conditions during the crisis had made it difficult for banks to respond to these funding pressures by reducing their US dollar assets. While European banks held a sizeable share of their net US dollar investments as (liquid) US government securities, other claims on non- bank entities – such as structured finance products – had been harder to sell into illiquid markets without realizing large losses.
• Other factors also hampered deleveraging of US dollar assets – banks brought off-balancesheetvehiclesbackontotheirbalancesheetsand prearrangedcreditcommitmentswere drawn. Indeed, the estimated outstanding stock of European banks’ US dollar claims actually rose slightly (by $248 billion or 3%) between Q2 2007 and Q3 2008.

• It was not until the fourth quarter of 2008 that signs of deleveraging emerged. The frequency of rollovers required to support European banks’ US dollar investments in non-banks became difficult to maintain as suppliersoffundswithdrewfromthemarket.

• Banks were, thus, forced to come up with US dollars, given their reliance on wholesale funding and short-term FX swaps. Essentially, the effective holding period of assets lengthened just as the maturity of funding shortened. This endogenous rise in maturity mismatch, difficult to hedge ex ante, generated the US dollar shortage.
• Banks reacted to the dollar shortage in various ways, supported by actions taken by central banks to alleviate the funding pressures.

• Prior to the collapse of Lehman Brothers (up to end Q2 2008), European banks tapped funds in the United States; their local US dollar liabilities booked by their US offices, which included their borrowing from Federal Reserve facilities, grew by $329 billion (13%) between Q2 2007 and Q3 2008, while their local assets remained largely unchanged.

• This allowed European banks to channel funds out of the United States via inter-office transfers, presumably to help their head offices replace US dollar funding previously obtained from the market. From the onset of the crisis to end Q1 2009, the lower bound estimate of European banks’ US dollar funding gap declined by nearly 50%.

• However, write-downs of securities and other mark-to-market losses during the crisis make this observed decline difficult to interpret. Specifically, write-downs of assets lead to decreases in the reported stock of US dollar claims, and thus a decline in net claims on non-banks.

Ideally, US dollar funding gap is measured directly, as the sum of net interbank funding, net FX swap transactions and (possibly) net liabilities to official monetary authorities, in order to pick up the changes in actual net short-term funding liabilities. However, in this analysis, the net FX swap positions are backed out as a residual. Thus, any write-down on the asset side is automatically reflected in a reduction in the estimated net FX swap positions. When asset write-downs are positive, the accuracy of the estimated US dollar funding gap thus depends on the extent to which banks actually unwound the funding positions supporting these written-down assets.

• If banks closed out all these funding positions by, for example, buying US dollars in the spot market, then the original estimate of the US dollar funding gap would have correct through end-Q1 2009.

• If, on the other hand, banks did not close out their funding positions, but rather rolled them over, then the observed measure would have underestimated the true funding gap by the amount of the write-downs.
• In this case, it is assumed that the bulk of European banks’ write-downs (estimated by Bloomberg at $423 billion between Q2 2007 and Q1 2009) were related to their US dollar- denominated non-bank assets, then their US dollar funding gap at end-Q1 2009 would be in the neighborhood of $880 billion – still down from the pre-crisis peak, but considerably higher than the estimated $583 billion gap which results when the funding positions are assumed to have been closed.

International Policy Response

• The severity of the US dollar shortage among banks outside the United States called for an international policy response.

• While European central banks adopted measures to alleviate banks’ funding pressures in their domestic currencies, they could not provide sufficient US dollar liquidity.

• Thus, they entered into temporary reciprocal currency arrangements (swap lines) with the Federal Reserve in order to channel US dollars to banks in their respective jurisdictions (as shown in the figure).

• Swap lines with the ECB and the Swiss National Bank were announced as early as Dec 2007.

• Following the failure of Lehman Brothers in September 2008, however, the existing swap lines were doubled in size, and new lines were arranged with the Bank of Canada, the Bank of England and the Bank of Japan, bringing the swap lines total to $247 billion.
• As the funding disruptions spread to banks around the world, swap arrangements were extended across continents to central banks in Australia and New Zealand, Scandinavia, and several countries in Asia and Latin America, forming a global network.

• Various central banks also entered regional swap arrangements to distribute their respective currencies across borders. On 13 October 2008, the swap lines between the Fed and the Bank of England, the ECB and the Swiss National Bank became unlimited to accommodate any quantity of US dollar funding demanded. The swap lines provided these central banks with ammunition beyond their existing foreign exchange reserves, which in mid-2007 amounted to $294 billion for the euro area, Switzerland and the United Kingdom combined.
• In providing US dollars on a global scale, the Federal Reserve effectively engaged in international lending of last resort. The swap network can be understood as a mechanism by which the Federal Reserve extends loans, collateralized by foreign currencies, to other central banks, which in turn make these funds available through US dollar auctions in their respective jurisdictions.
• This made US dollar liquidity accessible to commercial banks around the world, including those having no US subsidiaries or insufficient collateral to borrow directly from the Fed.

• The quantities of US dollars actually allotted through US dollar auctions in Europe provide an indication of European banks’ US dollar funding shortfall at any point in time. Most of the Federal Reserve’s international provision of US dollars was indeed channeled through central banks in Europe, consistent with the finding that the funding pressures were particularly acute among European banks.

• Once the swap lines became unlimited, the share provided through the Euro system, the Bank of England and the Swiss National Bank combined was 81% (15 October 2008).

• Reflecting considerable demand in the aftermath of the Lehman bankruptcy, the amount of US dollars provided globally through international dollar swap lines surged in October 2008, and peaked at $583 billion in December 2008. Since then, the use of swap lines has gradually subsided, to $50 billion by early October 2009. In tandem, the level and spreads of US dollar interest rates, notably Libor, have receded from their historical peak in autumn 2008.
• There is evidence that the US dollar auctions reduced the level and volatility of swap spreads. The policy also helped avert more extensive distress-selling of dollar-denominated assets, and possibly mitigated interbank rate volatility and upward pressure on the US dollar.

• Beyond addressing the immediate exigencies, however, the international swap arrangements are of broader interest from an institutional perspective. The structure of the arrangements appears to overcome two challenges commonly associated with international lending of last resort-
  • i) The Federal Reserve and its foreign counterparts have the power, in principle, to create any amount of money, in contrast with international financial institutions administering limited resources. Demands in other currencies can similarly be met by including the respective currency-issuing central banks in the network of swap lines.
  • ii) The swap network does not compound the informational problems that can give rise to moral hazard. By lending against collateral to foreign central banks that intermediate those funds to banks in their jurisdictions, the Federal Reserve assumes no credit risk vis- a-vis the ultimate borrowers, and delegates the task of monitoring the banks (or collateralizing the loans) to the national authorities closer to the bank supervision process.