The global financial crisis started in 2007 when European banks came under increasing strain. If forced to specify the crisis kickoff, we would pick Thursday, August 9, the day that BNP Paribas halted redemptions from three investment funds because it couldn’t value their holdings of U.S. mortgages. Responding to the ensuing market scramble for liquidity, the ECB injected €95 billion that day into the European banking system and the Federal Reserve put $24 billion in theirs. Today, with the benefit of hindsight, these numbers appear quaint, but then they seemed enormous. (You can find a contemporary account by one of us here.)
With time we learned that banks in Europe and elsewhere outside the United States had been borrowing a large volume of dollars in short-term money markets and investing in U.S. mortgage-backed securities. As the mortgages started to default and the securities lost value, the non-U.S. banks had trouble rolling over their short-term debt. Researchers eventually estimated the dollar shortfall to be well over $1 trillion!
That significant parts of the global financial system are running on dollars is no surprise. We discussed some of the basics – the fact that the dollar accounts for 80% of trade finance and 87% of foreign currency market transactions – in an earlier post on the reserve currencies. But there is more, much more.
The fact of the matter is that there is a parallel dollar-based financial system – call it the "Global Dollar system" – that operates outside the United States.
Using data from the BIS, we can estimate the size of this Global Dollar system. Starting with U.S. dollar liabilities of banks outside the United States, we quickly get around $13 trillion. (If you have a dollar-denominated account in a bank in London, Zurich or Hong Kong, it would be included in this sum.) Now, not all countries report to the BIS, so this subtotal is incomplete. China and Russia are missing, for example. In addition, Ecuador, El Salvador and Panama are dollarized, so their banks are issuing dollar liabilities. Tallying these non-reporting sources may add another $1 trillion. Next come a few trillion dollars more from dollar-denominated securities that are issued outside the United States (mostly in London).
All of this leads us to conclude that there is a second dollar-based financial system in which firms – mostly financial institutions – have issued dollar liabilities of more than $15 trillion. This volume of Global Dollars exceeds the total liabilities of banks operating within the United States.
Who should be concerned about this? In 1971, President Nixon’s Treasury Secretary John Connolly famously told an assembled group of European finance ministers: “The dollar is our currency, but your problem.” He was speaking about exchange rates, expressing a view that was already questionable 40 years ago.
Applied today to the global system of dollar finance, it is patently false. The world’s largest intermediaries are now so interdependent that if one gets into trouble, others may, too. And the market for short-term dollar funding is unified globally. Consequently, if a systemic bank in Europe finds itself unable to roll over dollar liabilities, it can be compelled to sell assets at fire sale prices and, possibly, default, incentivizing other banks to cut lending and hoard safe assets.
Such contagion puts the entire financial system at risk, making it everyone’s problem. By lending to a solvent but (temporarily) illiquid bank, a central bank can limit a liquidity crisis. Indeed, it was the frequent banking panics of the late 19th and early 20th century that led to the creation of the Federal Reserve System as the U.S. lender of last resort, the role already played by the European central banks of the day.
Yet, today’s two dollar-based financial systems differ in one absolutely critical respect: Banks operating or based in the United States have access to the Federal Reserve’s discount window, so when they suddenly need dollars they can easily get them, provided that they are solvent. Other solvent banks have no such access.
Had the Federal Reserve merely accepted that dichotomy, the crisis of 2007-2009 would have gotten much deeper much faster as leading European banks dumped assets or defaulted! Instead, in December 2007, the Fed introduced one of its most successful crisis mitigation tools, offering to lend U.S. dollars to foreign central banks that they could in turn lend to their banks. Recognizing that fire sales and defaults of these foreign banks posed a systemic threat back home, the Fed eventually provided 14 other central banks with large (in some cases, unlimited) dollar swap lines to meet the surge in funding dollar needs. (The official announcements are all available here.) At the height of the crisis in December 2008, the amount lent peaked at nearly $600 billion (see chart below).
Federal Reserve Liquidity Swaps with Foreign Central Banks (U.S. dollars in billions)
Countries without access to the Federal Reserve swap lines had to find other alternatives. Some, like Argentina, Brazil, and the Philippines, offered banks access to their foreign exchange reserves. Others, including Colombia and Poland, borrowed from the IMF through its Flexible Credit Line.
Policy innovation in the heat of a crisis is one thing. What mechanism should we design now for the Global Dollar system when we can plan ahead? How should we manage the system’s needs and risks? Let’s look very quickly at the options.
We could try to control its size using prudential tools, but that may just shift activity to another jurisdiction. It is difficult to keep people from making promises to provide dollars, even when they don’t have them. A second possibility would be to commit now not to provide central bank dollar swap lines in order to force governments to use their own dollar foreign exchange reserves. Official dollar reserves roughly match the $15-trillion scale of the dollar-based system outside the United States, but the current distribution is a problem: most of the reserves are in China, Japan, India and Brazil, while most of the dollar liabilities are issued by banks in Europe.
Third comes the IMF. Here, we see three stumbling blocks. First, the IMF doesn’t currently have the resources. Second, many investors view borrowing from the IMF as a sign of desperation, making it a risky thing for a country to do if it hopes to limit a panic. And third, relying on IMF credit could politicize this process.
This leaves the Fed’s swap lines. We agree with those who expect these will play an enduring role. Indeed, having already provided swaps in the crisis, a Fed commitment not to do so in the future may not be credible, rendering it ineffective in compelling governments to rely on their own currency reserves.
But, if dollar swap lines are to be part of the permanent crisis response toolkit, we need a clear set of rules to prevent banks outside the United States from relying too heavily on dollar loans from central banks. (A recent summary of the debate is here.) Generalizing the usual lender-of-last resort practices, rules that ensure a Bagehot-like penalty rate for borrowers, require high-quality collateral, and forbid lending to insolvent banks make sense. Above all, it is important that these rules be clarified before the next crisis inevitably hits the Global Dollar system. Otherwise, they will do little to promote financial stability.
The dollar is the currency of the United States, but in the 21st century, the risks associated with dollar funding are everyone’s problem!