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International Liquidity Provision and Currency - Specific Liquidity Shortages

Journal 34: Cass-Capco Institute Paper Series on Risk

Richhild Moessner, William A. Allen

In this paper we discuss the main innovation in central bank cooperation during the financial crisis of 2008-09, namely the emergency provision of international liquidity through the establishment of bilateral central bank swap facilities, which have evolved to form interconnected swap networks. Based on the BIS international locational banking statistics, we present a measure of currency-specific liquidity short-ages for the U.S. dollar, the euro, the yen, the pound sterling, and the Swiss franc for a large number of advanced and emerging economies.

We discuss the reasons for establishing swap facilities, relate our measure of currency-specific liquidity shortages to the probability of a country receiving a swap line in that currency, and find a significant relationship in the case of the U.S. dollar, the euro, the yen, and the Swiss franc. We find that countries with larger U.S. dollar shortages on our measure, and economies that are large international financial centers, have a statistically significantly higher probability of receiving a U.S. dollar swap line. We also find that actual U.S. dollar funding obtained by drawing on the Fed’s swap lines at end-2008 was statistically significantly larger for economies with higher U.S. dollar shortages on our measure, as well as for economies which are large international financial centers.

The advent of the credit crunch in August 2007, and its subsequent intensification, has largely eroded the hitherto apparently sharp distinction between monetary and financial stability, and has led to a revival of central bank cooperation. In this paper, we study the main innovation in central bank cooperation during the financial crisis of 2008-09, namely the establishment of bilateral central bank swap facilities, which have evolved to form interconnected swap networks. Obstfeld et al. (2009) describe these facilities as “one of the most notable examples of central bank cooperation in history.

”The credit crisis was initiated by a widespread, though not uniform or complete, loss of confidence in the creditworthiness of banks. It began suddenly in August 2007, and varied in intensity throughout the following year. Perceived counterparty credit risks increased sharply, owing to uncertainty about other banks’ credit exposures and the size of potential losses, and banks started hoarding liquidity. Spreads between Libor rates and Overnight Index Swap rates (OIS) widened and became highly volatile. The credit crisis damaged the functioning of all financial markets, including the wholesale deposit and foreign exchange swap markets [Baba et al. (2008); Baba and Packer (2009); and Allen and Moessner (2010)]. The crisis became much more acute after the failure of Lehman Brothers in September 2008, which destroyed the widespread belief in financial markets that governments would not allow any systemically-important financial institution to fail, and thereby dramatically heightened perceptions of credit risk among trading counterparties in financial markets.

In many countries, banks had made loans in foreign currencies, particularly those currencies in which interest rates had been relatively low, notably the U.S. dollar, the yen, and the Swiss franc. They had financed those loans partly by taking deposits in the currency of the loan, typically in the international wholesale deposit market, and partly by taking deposits in their home currencies, and using the foreign exchange swap market to eliminate foreign exchange risk.

When the credit crisis struck, it became much more difficult, or in some cases impossible, for many banks to secure foreign currency deposits in the wholesale markets. Even in domestic currency markets, the available range of maturities became much shorter. Many banks were forced to use the lending facilities of their home central banks to finance them-selves. Such facilities were in normal times typically confined to their domestic currency and to short maturities. Consequently, in the absence of any new special facilities designed to help them, banks would have had to replace relatively long-maturity foreign currency financing of foreign currency assets with relatively short-maturity domestic currency financing. The financial market consequences would have made the disruption caused by the credit crisis substantially more serious, as described in Allen and Moessner (2010), and the main purpose of the swap networks was to avoid those consequences.

Swap facilities can be used as a means of making the provision of central bank liquidity more effective by extending its geographical scope. Typically, central bank lending to domestic commercial banks is denominated in domestic currency, but if the commercial banks need foreign currency liquidity, then something more is required if the central bank wants to ad-dress this need. Swap facilities enable a central bank to provide liquidity to domestic banks in foreign currency.

In this paper, we study the emergency provision of international liquidity through the establishment of bilateral central bank swap facilities, which have evolved to form interconnected swap networks. We present a measure of currency-specific liquidity shortages for the U.S. dollar, the euro, the yen, the pound sterling, and the Swiss franc for a large number of advanced and emerging economies, based on the BIS international locational banking statistics. We discuss the reasons for establishing swap facilities, relate our measure of currency-specific liquidity shortages to the probability of a country receiving a swap line in that currency, and find a significant relationship in the case of the U.S. dollar, the euro, the yen, and the Swiss franc. Moreover, we find that economies which are large international financial centers have a statistically significantly higher probability of receiving a U.S. dollar swap line from the Federal Reserve, as well as from any country. We also find that actual U.S. dollar funding obtained by drawing on the Fed’s swap lines at end-2008 was statistically significantly larger for economies with higher U.S. dollar shortages on our measure, as well as for economies which are large international financial centers.

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