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P2.T8.20.16. The US dollar shortage during the global financial crisis (McGuire)

Nicole Seaman

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Learning objectives: Identify the causes of the US Dollar shortage during the Great Financial Crisis. Evaluate the importance of assessing maturity/currency mismatch across the balance sheets of consolidated entities. Discuss how central bank swap agreements overcame challenges commonly associated with international lenders of last resort.


20.16.1. According to Patrick McGuire, which of the following best summarizes the proximate cause of the US dollar shortage during the global financial crisis (GFC)?

a. Depositors initiated a classic run on the banks and converted their domestic deposits to foreign currency
b. The effective maturity of banks’ dollar funding lengthened while their dollar assets shortened, and this decreased their maturity mismatch.
c. The effective maturity of banks’ dollar funding shortened while their dollar assets lengthened, and this increased their maturity mismatch.
d. Banks shifted their portfolios to non-bank assets that included banks’ retail and corporate lending, lending to hedge funds, and holdings of securities ranging from US Treasury and agency securities to structured finance products

20.16.2. Imagine 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; for example, a German bank’s investment in US dollar-denominated structured finance products. The bank can finance these foreign currency positions in three ways:

I. The bank can borrow domestic currency, and convert it in a straight FX spot transaction to purchase the foreign asset in that currency.​
II. The bank can also use FX swaps to convert its domestic currency liabilities into foreign currency and purchase the foreign assets.​
III. The bank can borrow foreign currency, either from the interbank market, from non-bank market participants, or from central banks​

Which option significantly exposes the bank to currency risk?

a. None of the options
b. Only option I. significantly exposes the bank to currency risk
c. Only option III. significantly exposes the bank to currency risk
d. All three of the options

20.16.3. The severity of the US dollar shortage during the global financial crisis (GFC) led to an international policy response. European central banks adopted measures to alleviate banks’ funding pressures in their domestic currencies, but by itself this did not provide sufficient US dollar liquidity. As a remedy, the Federal Reserve introduced a system of reciprocal currency arrangements called "swap lines" with other central banks. As McGuire explains, "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.33 This made US dollar liquidity accessible to commercial banks around the world, including those that have no US subsidiaries or insufficient eligible collateral to borrow directly from the Federal Reserve System." (Patrick McGuire, Gotz von Peter, 2009. “The US Dollar Shortage in Global Banking and the International Policy Response,” BIS Working Papers, Bank for International Settlements.)

Such lending of last resort (LOLR) might present two sorts of classic problems: One, Is there enough money to reassure markets, or is the money limited? Two, What sort of moral hazard is created? A successful swap program overcomes these problems with specific benefits:

I. It has the power to create an unlimited amount of money​
II. It does not create a new moral hazard(s)​

According to McGuire, which of these benefits did the international response to the GFC (i.e., the Fed's swap lines) confer?

a. Neither
b. Only I.
c. Only II.
d. Both benefits

Answers here: