Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 16. The US Dollar Shortage

Presented by: Sudhanshu

Module 1. Global Bank Balance Sheets and Vulnerabilities

Module 2. US Dollar Shortage and International Policy Response

Module 1. Global Bank Balance Sheets and Vulnerabilities

Topic 1. Global Balance Sheets and Funding Risk

Topic 2. Vulnerabilities in Balance Sheets

Topic 1. Global Balance Sheets and Funding Risk

• Decade of Expansion (Pre-2007)

1. Scope of Analysis:

• Vulnerabilities are measured across the fully consolidated operations of global banks, looking at the entire global balance sheet.

• National balance sheets alone are not sufficient indicators of systemic stress.

2. Asset Growth:

• The decade leading to 2007 saw a significant expansion of banks' investment portfolios.

• Banks aggressively increased their holdings of U.S. dollar loans and structured products globally.

• Total foreign claims more than tripled, rising from $10 trillion in 2000 to $34 trillion by the end of 2007.

• U.S. dollar denominated positions accounted for over half of this massive increase in foreign assets.

• Three Ways Banks Financed Foreign Assets

• Banks generally used one of three methods to obtain the U.S. dollars needed to purchase foreign (USD) assets:

1. Domestic Borrowing and Spot FX: Borrow in their home currency, convert it to U.S. dollars in the spot market, and then buy the asset. This requires hedging the resulting unhedged U.S. dollar position, typically with FX swaps.
2. FX Swaps: Convert their domestic currency liabilities into U.S. dollars directly using foreign exchange (FX) swaps to fund the asset purchase.
3. Direct USD Borrowing: Borrow U.S. dollars directly from other participants in the interbank markets or, if eligible, from the central bank.

• ​T​he Critical Mismatch

1. Funding Risk:

• This is the risk that a bank will be unable to roll over its maturing liabilities—especially short-term ones—in stressed market conditions.

• Failure to roll over forces the bank to sell foreign currency assets, likely incurring a significant loss (a distressed sale).

2. The Currency Dimension:

• Domestic funding risk is minimized because the central bank acts as the lender of last resort (LLR).

• However, central banks cannot create foreign currencies. Banks must obtain foreign currencies (like USD) in the international markets, making foreign currency funding risk critical.

1. Domestic Borrowing and Spot FX: Borrow in their home currency, convert it to U.S. dollars in the spot market, and then buy the asset. This requires hedging the resulting unhedged U.S. dollar position, typically with FX swaps.
2. FX Swaps: Convert their domestic currency liabilities into U.S. dollars directly using foreign exchange (FX) swaps to fund the asset purchase.
3. Direct USD Borrowing: Borrow U.S. dollars directly from other participants in the interbank markets or, if eligible, from the central bank.

• ​T​he Critical Mismatch

1. Funding Risk:

• This is the risk that a bank will be unable to roll over its maturing liabilities—especially short-term ones—in stressed market conditions.

• Failure to roll over forces the bank to sell foreign currency assets, likely incurring a significant loss (a distressed sale).

2. The Currency Dimension:

• Domestic funding risk is minimized because the central bank acts as the lender of last resort (LLR).

• However, central banks cannot create foreign currencies. Banks must obtain foreign currencies (like USD) in the international markets, making foreign currency funding risk critical.

3. The Funding Gap (Definition LO 81.b):

• The gap is a foreign currency mismatch.

• It occurs when the investment horizon of foreign currency assets significantly exceeds the time to maturity of the foreign currency liabilities used to fund them.

3. The Funding Gap:

• The gap is a foreign currency mismatch.

• It occurs when the investment horizon of foreign currency assets significantly exceeds the time to maturity of the foreign currency liabilities used to fund them.

Practice Questions: Q1

Q1. If the maturity of a bank’s U.S. dollar liabilities to nonbanks is longer term, a(n):
A. lower bound of the U.S. dollar funding gap can be established as the net U.S. dollar position to nonbanks.

B. upper bound of the U.S. dollar funding gap can be established as the net U.S. dollar position to nonbanks.
C. lower bound of the U.S. dollar funding gap can be established as the gross U.S. dollar position to nonbanks.
D. upper bound of the U.S. dollar funding gap can be established as the gross U.S. dollar position to nonbanks.

Practice Questions: Q1 Answer

Explanation: A is correct.

If the maturity of U.S. dollar liabilities to nonbanks is longer-term, a lower bound of the U.S. dollar funding gap can be established as the net U.S. dollar position to nonbanks. If the maturity of U.S. dollar liabilities to nonbanks is shorter-term, an upper bound of the U.S. dollar funding gap can be established as the gross U.S. dollar position to nonbanks.

Topic 2. Vulnerabilities in Balance Sheets

• Seeing Vulnerabilities in the Consolidated Entity

​1. Nationality vs. Residency: Large global banks operate across multiple jurisdictions.

• Foreign offices book the majority (over 50%) of a bank’s foreign currency claims.

• Positions booked by a local office are only a small part of a bank’s external assets.

2. The Consolidation Issue: Local currency or maturity mismatches at an individual office are often intentionally left unhedged if they are offset at the consolidated group level.

• Therefore, national balance sheets are poor indicators of a bank's true vulnerability.

• Stresses and vulnerabilities can only be accurately observed when looking at the global balance sheet of the consolidated entity.

• Cross-Currency Funding and Open Positions: The Creation of the Short USD Position

  • Funding Mechanism: As banks expanded their global asset purchases, foreign currency assets often exceeded the available funding in those currencies. This difference was often financed by borrowing in the bank’s domestic currency at home.

  • Hedging: Extensive use of FX swaps ensured that the resulting on-balance sheet open cross-currency net positions remained small.

  • The Exposure: This activity created a massive short-term U.S. dollar liability exposure, primarily in Europe. By mid-2007, the combined long U.S. dollar asset positions of European banks, funded by short positions in their home currencies (EUR, GBP, CHF), grew to nearly $700 billion.

• The Size of the U.S. Dollar Funding Gap: Rollover Risk Quantification

  • The funding gap is measured as the difference between a bank’s USD long-term assets and its USD long-term liabilities. This is the amount of USD that needs to be rolled over before asset maturity.

  • Lower Bound Estimate: Assuming longer-term nonbank liabilities, the net U.S. dollar position to nonbanks established a lower bound estimate.

    • Result: The gap was estimated at $1 - $1.2 trillion by European banks in mid-2007.

  • Upper Bound Estimate: Assuming short-term nonbank liabilities (e.g., money market funding), the gross U.S. dollar position to nonbanks established an upper bound estimate.

    • Result: The gap increased to an estimated $2 - $2.2 trillion.

  • This material funding gap was financed largely by short-term interbank borrowing and FX swaps, creating extreme fragility when those markets froze.

• ​Causes of the U.S. Dollar Shortage: The Funding Crisis Escalates

  • Destabilization: Rising counterparty and liquidity risks destabilized short-term funding markets, increasing costs for banks trying to secure USD via currency swaps.

  • Market Withdrawal: Money markets withdrew from purchasing bank-issued paper, and central banks globally withdrew sizable portions of their U.S. dollar foreign exchange reserves.

  • Asset Distress: Banks found it difficult to sell illiquid U.S. dollar assets, such as structured products, without incurring significant losses.

  • Balance Sheet Inversion: Off-balance sheet vehicles were brought back onto banks' balance sheets, and prearranged credit commitments were drawn.

• The Crunch: The holding period of assets lengthened (because they couldn't be sold), while the funding maturity shortened (due to lack of rollovers), creating a severe U.S. dollar shortage.

• Note: Asset write-downs during the crisis made estimating the true remaining funding gap complex.

Practice Questions: Q2

Q2. Prior to 2007, banks would least likely finance their increasing investment holdings of U.S. dollar assets by:
A. drawing on U.S. dollar bank credit lines.
B. borrowing U.S. dollars from their central bank.
C. borrowing U.S. dollars directly in the interbank markets.
D. borrowing in their domestic currency and converting it to U.S. dollars in the spot market.

Practice Questions: Q2 Answer

Explanation: A is correct.

Banks could finance their increasing investment holdings of U.S. dollar assets by
borrowing in their domestic currency and converting it to U.S. dollars in the spot
market, or by borrowing U.S. dollars directly in the interbank markets, from other
market participants or from their central bank. Banks could also convert their
domestic currency liabilities into U.S. dollars using FX swaps to buy the asset.

Practice Questions: Q3

Q3. The funding gap can be best defined as:
A. a mismatch between banks’ domestic and foreign currency obligations.
B. the difference between banks’ foreign currency and domestic currency reserves.
C. the difference between a bank’s collateralized and noncollateralized foreign borrowings.
D. a foreign currency mismatch if the investment horizon of the foreign currency assets exceeds the time to maturity of the foreign currency liabilities.

Practice Questions: Q3 Answer

Explanation: D is correct.

A bank’s funding gap is best defined as a foreign currency mismatch if the investment horizon of the foreign currency assets exceeds the time to maturity of the foreign currency liabilities.

Module 2. US Dollar Shortage and International Policy Response

Topic 1. Causes of the 2007–2009 U.S. Dollar Shortage

• Triggering Factors:

  • Maturity Transformation: Shift toward less stable short-term funding.

  • FX Swap Market Disruptions: Rising counterparty & liquidity risks increased USD borrowing costs.

  • Money Market Retreat: Pulled away from bank-issued paper.

  • Central Bank Actions: Reduced USD foreign exchange reserves.

  • Asset Illiquidity: Hard to sell structured products & other non-government USD assets without large losses.

  • Balance Sheet Pressure:

    • Off-balance sheet vehicles brought back on-balance sheet.

    • Pre-arranged credit commitments drawn.

• Mechanics of the Shortage:

  • As USD assets matured, banks needed to roll them over.

  • Before crisis, rollovers funded mainly via nonbank market & short-term FX swaps.

  • Post-crisis: Assets couldn’t be rolled over → holding period lengthened while funding maturity shortened.

• Gap Estimates (Q1 2009):

  • Lower bound: $583B (assumes banks closed positions).

  • Adjusted (true) gap: $880B (if positions rolled over and write-downs hid exposures).

• Example: Before Lehman’s collapse, many banks sourced USD from their U.S. offices (borrowing from the Fed as primary dealers) and transferred funds via interoffice transfers.

Topic 2. International Policy Response by Central Banks

• Problem: Non-U.S. central banks lacked sufficient USD to meet domestic banks’ needs.
• Solution – USD Swap Lines with the Fed:

  • Mechanism:

    • Fed lends USD to foreign central bank, collateralized by foreign currency.

    • Central bank distributes USD locally (often via auctions).

    • Allowed even banks without U.S. subsidiaries or eligible collateral to access USD liquidity.

  • Early Partners (2007): ECB & Swiss National Bank.

  • Post-Lehman Expansion: Added Bank of England, Bank of Canada, Bank of Japan, Reserve Banks of Australia & New Zealand, Latin America, and Asia.

• Late 2008 Enhancement:

  • Unlimited Swap Lines with ECB, SNB, Bank of England → Fed as global lender of last resort.

• Impact:

  • Usage fell from $583B peak → ~$50B by late 2009.

  • Prevented distressed USD asset sales.

  • Reduced interbank rate volatility.

  • Eased USD appreciation pressure.

• Institutional Benefits:

  • Fed can create unlimited USD — model could work for other currencies.

  • Collateralized → No counterparty risk; credit monitoring done by local central bank.

• Example of Scale: After unlimited lines were introduced, ECB, Bank of England, and SNB accounted for ~80% of total swap usage.

Practice Questions: Q1

Q1. Which of the following factors is least likely a contributor to the U.S. dollar shortage during the financial crisis?
A. Banks’ prearranged credit commitments were drawn.
B. Structured finance products became more difficult to sell.
C. Central banks globally reduced their issuance of U.S. dollars.
D. Banks brought off-balance vehicles back to their balance sheets.

Practice Questions: Q1 Answer

Explanation: C is correct.

Central banks outside of the U.S. can only issue their domestic currency. Only the Fed can issue U.S. dollars. Some of the factors that contributed to the U.S. dollar shortage and increasing difficulty for banks to fund their U.S. dollar obligations included difficulty in selling less liquid structured products, bringing off-balance-sheet vehicles onto banks’ balance sheets, and drawing prearranged credit commitments.

Practice Questions: Q2

Q2. Which of the following statements about the U.S. dollar swap lines extended by the Fed to global central banks during the 2007–2009 financial crisis is least accurate?
A. Swap lines could be unlimited.
B. Swap lines were primarily uncollateralized.
C. The Fed can be seen as a lender of last resort.
D. Central banks typically made funds available locally through auctions.

Practice Questions: Q2 Answer

Explanation: B is correct.

Swap lines to central banks were collateralized by foreign currencies.
The swap lines to some of the largest central banks globally were made unlimited in 2008. As a result, the Fed can be seen as a lender of last resort. Borrowing central banks typically made the funding they obtained through the swap network available locally through U.S. dollar auctions.