Managing Global Dollar Liquidity During the 2007–2009 Financial Crisis
The Financial Crisis Forced Interest Rates Lower
But with the onset of the crisis in 2007, these banks saw their access to dollar funding come under tremendous stress—with potentially dire consequences for financial markets and real activity associated with banking. The economy interest rates and deposit rates move in tandem, forcing the Fed’s hand in raising or lowering rates.
Credit tiering among banking counterparties continued, as did some self-selection of less creditworthy banks that continued to seek liquidity from the central banks auctioning dollars.
Overall, taking into account the consequences of the auction structures and collateral considerations, we observe that the continued participation of some banks in the CB dollar swap auctions through the first half of 2009 reflected persistent pockets of supply shortages in the dollar markets.
CB dollar swaps
Net dollars outstanding through the CB dollar swaps peaked at nearly $600 billion toward the end of 2008, as banks hoarded liquidity over year-end, although some of this demand for dollars began to unwind following year-end. In addition, the continuing globalization of capital markets increasingly provided investment opportunities in nondomestic currencies for banks and investors globally.
In the decade prior to the financial crisis, the dollar-denominated assets of foreign banks, especially institutions in Europe, increased dramatically. The progression of market stresses led the Federal Reserve in December 2007 to establish central bank (CB) dollar swaps: reciprocal currency arrangements with several foreign central banks that were designed to ameliorate dollar funding stresses overseas. All are driving factors in forcing mortgage rates lower to new levels.
Central Bank Dollar Swap Lines initially up to three months, six months later, ultimately returning to primarily shorter tenors. Correspondence: Linda. The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.
Two measures are used to show the increased cost of dollar funds in private markets during the crisis. In this article, we provide an overview of the CB dollar swap facilities, discuss the changes in breadth and volume as funding conditions (both in the market and through the facilities) evolved, and assess the economic research documenting the efficacy of the swaps.
The on-balance-sheet dollar exposures of euro area, United Kingdom, and Swiss banks were estimated to exceed $8 trillion in 2008, of which $1 trillion to $3 trillion was funded through short-term sources. We conclude in Section 6 with more forward-looking comments on the importance of currency swap facilities as part of a central bank’s toolbox for managing and resolving crises.
Demand for Dollars
To provide perspective on the pressures banks faced in the crisis period, we begin with the issue of how many U.The growth in dollar exposures can be attributed to a number of factors.We compare the average price of federal funds during morning hours with the average price during afternoon trading.
By comparing the interest cost of euros for stronger, more moderate, and lower rated financial institutions in Europe, we conclude that the degree of credit tiering peaked in November 2008 and remained elevated well into the third quarter of 20 Third, we discuss the key findings, as well as the limitations, of a range of relevant econometric studies of the CB auctions’ effects during the crisis.
Indeed, with funds at the TAF priced below indicative market rates for many banks, and with the minimum bid rate at the TAF the same as the rate of interest on excess reserves, participation in the TAF remained broad through much of 20 In contrast, the dollar auctions of other central banks had dollars priced above the market rates that were available to many banks. Section 5 presents evidence of the dollar swap facilities’ effects on liquidity conditions in financial markets in the United States and abroad.
Based on the effects on financial market spreads, the studies conclude that the TAF and the CB dollar swaps played important roles in reducing the cost of funds, especially when dollar liquidity conditions were under the most stress. The main methodology is a type of event study that tracks the consequences for financial variables of announcements about liquidity facilities, whether these pertain to amounts to be offered, scope of access, or actual auction dates.
One piece of evidence comes from the Euro Interbank Offered Rate (Euribor) panel, where the FX swaps’ implied basis spreads on dollars were quite different across banks with different strength ratings. The Bank of Japan had a balance of $100 million in twenty-nine-day funds, initiated on January 14, 2010, that matured on February 12 20 We do not explore here the reintroduction of the CB dollar swaps in May 20 for banks seeking access to liquidity.
Pressures in Dollars
Funding Mar.kets In this section, we provide an overview of the initial pressures in dollar funding markets and the evolution of these pressures over time.Among the explanations is the view that this spread can be interpreted partially as a “European premium” that evthroughoutrse of the crisis as a result of dollar demand by European banks lacking a natural dollar deposit base for meeting dollar funding needs.
These arrangements expanded as the crisis continued throughout 2008 and they remained in place through the end of 2009, becoming an important part of global policy cooperation. At the program’s peak, longer-term swaps dominated the total amount outstanding.
We conclude that the CB dollar swap facilities are an important tool for dealing with or minimizing systemic liquidity disruptions, as demonstrated in the reintroduction of the swaps on May 20. We begin by describing the dollar funding needs of foreign banks and examining the private cost of dollars before, during, and after the crisis.
After starting in 2007, the Federal Reserve’s program for providing dollars to foreign markets evolved extensively with respect to both the number of countries with swap agreements and the amount of dollars made available abroad. In brief, the high level of dollar-denominated assets that European banks were exposed to, both on and off balance sheet, and the banks’ heavy reliance on short-term, wholesale markets to fund these assets exacerbated the significant strains in funding markets during 2008 and into 20 The foreign currency exposures of European banks had grown significantly over the decade preceding the crisis.
Amounts outstanding at the dollar swap facilities declined to less than $100 billion by June 2009, to less than $35 billion outstanding by October 2009, and to less than $1 billion by the time the program expired on February 1, 201 In Section 4, we show the differential costs of accessing dollars at the official liquidity facilities, with the effective “allin” cost of dollars at the various central banks deriving from the specific facility designs and collateral policies.
First, we share anecdotal accounts from market participants—including dealers, brokers, and bank treasurers—who argue that the CB dollar swaps contributed to improved market conditions. This “morning premium” persisted through December 2008, reaching elevated levels following the bankruptcy of Lehman Brothers.
The first is the spread between the London interbank offered rate (Libor) and the overnight index swap (OIS) rate. The differential in cost was normally close to zero in the precrisis period through August 2007 and thereafter evolved to reflect a substantial premium paid for federal funds acquired in morning trading.
Dollar FRBNY Economic Policy Review May 2011
5 exposures accounted for half of the growth in the banks’ foreign exposures over the 2000-07 period. We consider some measures of the cost of funds across markets and tenors, showing how the measures evolved over the period covered by the CB dollar swaps.
The second measure is the foreign exchange (FX) swap implied basis spread, which reflects the cost of funding dollar positions by borrowing foreign currency and converting it into dollars through an FX swap. The tenor of funds made available through the dollar auctions also evolved, increasing from up to one month.
We show that, while funds obtained through the dollar swap facilities were competitively priced in the early stages of the crisis, the dollars acquired through overseas dollar swap facilities eventually cost more than those from the Federal Reserve’s Term Auction Facility (TAF) or, as money market functioning improved, from the private market for most borrowers. While the results are compelling, we note the difficulty in using such studies as conclusive metrics of market effects.
Among them are differences in the bank regulatory framework that allowed European banks to invest in many of the highly rated, dollar-denominated structured finance products that proliferated at the time. Second, we argue that, despite the overall improvement, credit tiering remained. This expiration date refers not to the maturity but to the last day for initiation of a swap. Additional evidence of disruptions to dollar markets is drawn from the intraday federal funds market.t
