Name the factors that produced the scarcity of US dollars during the Great Financial Crisis.
The idea
Before 2008 large non-US banks, especially European ones, built big US dollar balance sheets of loans, structured credit and securities held in the US and in their foreign offices. They had few US dollar retail deposits, so they funded the gap between dollar assets and stable dollar liabilities in wholesale markets. These were short-term interbank loans, certificates of deposit sold to US money market funds, and foreign exchange swaps in which euros or other currencies were swapped into dollars for weeks or months. That is maturity transformation in a foreign currency, and it depends on continual rollover. When confidence fell in 2007 and collapsed after Lehman in September 2008, money market funds withdrew and counterparty fears froze interbank lending and swap markets. No home central bank could create dollars. The exam point is that the shortage came from the funding structure and rollover risk, not from a lack of dollars in the world.
A practice question
Which feature of the balance sheets of large non-US banks before 2008 is the main reason a shortage of US dollars could develop in the crisis?
- Dollar assets funded by short-term wholesale borrowing rather than stable dollar deposits - correct
- Heavy holdings of US Treasury securities that lost value when yields fellWhy not: Treasuries rallied in the crisis; the shortage came from funding structure, not from losses on safe assets.
- A fixed exchange rate between the euro and the dollar that obliged the banks to hold dollar reservesWhy not: No such peg existed; this confuses an exchange rate regime with a funding problem.
- Excess US dollar retail deposits that US households withdrew in 2008Why not: Non-US banks had little dollar retail funding to lose; the reliance was on wholesale markets.
The banks held dollar assets worth far more than their stable dollar liabilities and filled the gap with short-term interbank, money market and foreign exchange swap funding. That funding had to be rolled over continually, so when lenders pulled back, the banks were short of dollars.
A harder one
A euro-based bank funds a dollar loan by borrowing euros, selling them for dollars spot and agreeing to buy the euros back in three months through a foreign exchange swap. Which risk makes this structure a channel for dollar shortage in a crisis?
- Outright exchange rate risk, because the swap leaves the bank with an open dollar positionWhy not: The swap fixes the forward rate, so the bank has hedged exchange rate risk; the exposure is to renewing the swap.
- Rollover risk, because the swap must be renewed every few months and counterparties may refuse to supply dollars - correct
- Credit risk on the US borrower, because a swap transfers the loan's default risk to the dealerWhy not: The swap does not transfer default risk on the loan; this confuses a funding instrument with credit protection.
- Interest rate risk on the loan, because the swap's forward points are fixed for the life of the loanWhy not: Forward points are fixed only for the swap's short tenor, and rate risk is not what makes dollars unobtainable in a crisis.
A rolling short-dated swap gives a currency-hedged but short-term dollar funding of a longer-dated asset. The shortage arises when counterparties will not roll the swap, not from exchange rate exposure.
The hardest tier
A non-US bank has USD 500 billion of dollar assets and USD 150 billion of stable dollar deposits from non-banks. The rest is funded with USD 130 billion of interbank borrowing and USD 220 billion of foreign exchange swaps, all short term. In a crisis interbank lenders withdraw fully and 60% of the swaps cannot be rolled. The dollars the bank must find elsewhere, for example from a central bank, are closest to:
- USD 350 billionWhy not: Treats the entire wholesale gap as lost; the stem says only 60% of the swaps fail to roll.
- USD 210 billionWhy not: Applies the 60% loss rate to the whole USD 350 billion wholesale gap, although the interbank lenders withdraw completely.
- USD 262 billion - correct
- USD 132 billionWhy not: Counts only the failed swaps (60% of 220) and forgets that the interbank funding also disappears.
The wholesale gap is 500 - 150 = 350. Lost funding = interbank 130 (100%) + 0.60 x 220 swaps = 130 + 132 = 262. Reliance on short-term wholesale funds of a foreign currency creates exactly this rollover exposure.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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