Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 15. 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

• Pre-2007, banks significantly expanded investment portfolios globally through international diversification, increasing holdings of U.S. dollar loans and structured products.
• Analysis focuses on fully consolidated global balance sheets, as stresses and vulnerabilities build up across the entire global balance sheet rather than at individual locations.
• Methods for funding foreign currency assets
  • Borrow in domestic currency, convert to U.S. dollars in spot market, and purchase the asset.
  • Convert domestic currency liabilities into U.S. dollars using FX swaps and purchase the asset.
  • Borrow U.S. dollars directly in interbank markets from other participants or central banks.
• Funding risk exposure
  • All funding methods expose banks to funding risk—the inability to roll over maturing liabilities.
  • A funding gap (foreign currency mismatch) occurs when foreign currency asset investment horizons exceed foreign currency liability maturities.
  • Inability to roll over liabilities due to stressed markets or illiquidity forces asset sales, possibly at significant losses.

Topic 1. Global Balance Sheets and Funding Risk

• Critical Difference: Domestic vs. Foreign Currency Risk
  • Domestic funding risk is minimized because central banks act as lenders of last resort with emergency liquidity.
  • Foreign currency funding risk is critical because central banks cannot create foreign currencies; banks must meet requirements directly in international markets.
• Measurement and Disclosure Challenges
  • Foreign currency funding risk must be measured across global consolidated balance sheets by examining maturity, currency, and counterparty mismatches.
  • Banks don't publicly disclose important international position details, making regulatory oversight challenging.
  • BIS statistics (1999-2009) provide comprehensive data on: consolidated foreign assets/liabilities, gross and net positions by currency, and financing sources.

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.

Topic 2. Importance of Banks' Foreign Offices

• Large banks manage currency and maturity positions globally, creating identified mismatches at individual office locations.
• Local mismatches may remain unhedged if offset by positions across foreign offices or hedged off-balance sheet, resulting in overall hedged positions on a consolidated basis.
• Foreign offices book the majority (typically over 50%) of banks' foreign currency claims, accounting for significant shares of consolidated balance sheet positions.
• Extreme example: Switzerland's foreign claims represent 80% of total consolidated assets, with nearly 80% booked in offices outside Switzerland.
• Cross-border positions accounted for between a quarter and half of external assets across 11 BIS-measured countries in 2007.
• Bank nationality differs from residency; positions booked by an office in a country represent only a small part of external asset positions, making national balance sheets poor indicators of vulnerabilities.
• Significant expansion of cross-border lending and foreign acquisitions pre-crisis meant that office choices for balance sheet adjustments had major implications.
• Foreign office adjustments created large variabilities in host countries' external positions (e.g., UK, Italy, Spain), making vulnerabilities difficult to observe without examining consolidated global balance sheets.

Topic 2. Global Balance Sheet Expansion

• Banks' total foreign claims more than tripled from $10 trillion (2000) to $34 trillion (2007), with annual growth accelerating to nearly 30% by 2007.

• The rate of growth in foreign claims also accelerated, with an annual growth in 2007 of nearly 30%.

• U.S. dollar-denominated positions (plus other non-euro currencies) contributed over half of the total increase in foreign assets.

• European banks primarily financed foreign claims in domestic currency through intra-euro area cross-border positions.

• UK, Japan, and Switzerland banks predominantly financed foreign claims in foreign currencies, primarily U.S. dollars.
• Foreign currency assets frequently exceeded funding in those currencies, with long foreign currency positions financed through domestic currency borrowing.
• Small on-balance sheet open cross-currency net positions indicated extensive hedging activity through FX swaps.
• Combined European banks held nearly $700 billion in long U.S. dollar positions (UK: $200B, German/Swiss: $300B, Dutch: $150B), funded by short positions in pounds, euros, and francs.

Topic 3. Maturity Mismatches and Funding Gap

• Funding gaps equal the difference between U.S. dollar long-term assets and long-term liabilities, measuring the U.S. dollars requiring rollover before asset maturity.
• Interbank claims have shorter maturities with greater liquidity; nonbank investments range from short-term treasuries and agency securities to long-term lending to corporate and hedge fund.
• Banks finance U.S. dollar investments through short-term interbank borrowing or even shorter-term FX swap borrowing.
• Additional nonbank funding sources include corporate and retail deposits, central bank deposits, and money market financing, each with different maturities.
• Bounds on Funding Gap
  • Lower bound: Net U.S. dollar position to nonbanks (assumes longer-term nonbank liabilities).
  • Upper bound: Gross U.S. dollar position to nonbanks (assumes shorter-term nonbank liabilities).
• Largest funding Gaps in mid 2007: German, Swiss, Dutch, and UK banks.
• German banks primarily relied on interbank funding; UK banks maintained more balanced positions across interbank funding, central bank deposits, and FX swaps.

Topic 3. Maturity Mismatches and Funding Gap

• BIS estimates: $1–1.2 trillion funding gap for European banks.
• Primary funding sources: Interbank markets and central bank borrowing, with FX swaps used to convert domestic currency funding to U.S. dollars.
• Assuming money market funding is short-term, the funding gap estimate increases to $2 trillion–$2.2 trillion.
• This material funding gap represented significant exposure to funding risk as the financial crisis began, creating vulnerabilities when banks faced difficulty rolling over short-term obligations.

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.

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.

Module 2. US Dollar Shortage and International Policy Response

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

• Triggering Factors:

  • Maturity Transformation and increase in funding gap: Shift toward less stable short-term funding.

  • FX Swap Market Disruptions: Rising counterparty & liquidity risks increased costs of USD borrowing through FX Swaps for banks.

  • 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 and 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. This scenario created a U.S. dollar shortage.

• Funding Gap: If the investment horizon of the foreign currency assets exceeds the time to maturity of the foreign currency liabilities (funding or FX swaps), a currency mismatch occurs which is known as funding gap.

• 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.
• During 2007 and 2008, banks’ U.S. dollar​ liabilities grew significantly, including their borrowings from the Fed, while their U.S. dollar assets did not change signifiicantly. This created a U.S. dollar funding gap.
• The lower bound of the funding gap declined by nearly 50% during the financial crisis.
• However, this decline is misleading because much of it was caused by asset write-downs, which reduce U.S. dollar asset claims and net claims by nonbank institutions, and also reduces the estimated net FX swap positions.
• Gap Estimates (Q1 2009)

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

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

Topic 2. Funding Gap

Topic 3. 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 of USD Swap Lines:

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

• 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:

  • The Fed's unlimited dollar creation capacity, distributed via international swap lines, demonstrates that swap lines can mitigate currency pressures beyond just the U.S. dollar.

  • Swap networks don't create moral hazard because lines are fully collateralized, eliminating Fed counterparty risk while other central banks handle credit monitoring of their own banks.

Topic 3. International Policy Response by Central Banks

Topic 3. International Policy Response by Central Banks

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.