Outline how central banks around the world responded to the dollar shortage and weigh up how well that response worked.
The idea
The core response was the central bank liquidity swap line. The Federal Reserve gave a foreign central bank dollars in exchange for that central bank's own currency at the current spot rate, with a commitment to reverse the trade at the same rate on a set date. The foreign central bank then lent the dollars to its own banks, usually in auctions against collateral, and carried the credit risk of those banks. The Fed bore no exchange rate risk because the reversal rate was fixed. Lines began with the ECB and Swiss National Bank in December 2007 and spread after Lehman to many central banks. They became unlimited for the ECB, Bank of England, Bank of Japan and Swiss National Bank in October 2008. Funding pressure eased once the lines were in place, though countries without lines had to rely on their own reserves. The exam point is that swap lines addressed the lender-of-last-resort gap in dollars but not the underlying mismatch.
A practice question
The main tool central banks used to relieve the dollar shortage during the Great Financial Crisis was:
- Direct dollar lending by the European Central Bank from its own stock of printed dollarsWhy not: Only the Fed can create dollars; other central banks had to obtain them from the Fed or from their reserves.
- A coordinated devaluation of the dollar against the euro and yenWhy not: Exchange rates were not the instrument; the response targeted the supply of dollar funding to banks.
- A requirement that foreign banks sell their dollar assets to the Federal ReserveWhy not: The Fed did not buy foreign banks' dollar assets for this purpose; it supplied dollars against collateral through central banks.
- Federal Reserve dollar liquidity swap lines with other central banks - correct
Under a swap line, the Fed gives dollars to a foreign central bank in exchange for its currency, and that central bank lends the dollars to its own banks.
A harder one
When a foreign central bank on-lends dollars obtained through a swap line to its domestic banks, who bears the credit risk of those banks?
- The foreign central bank, which lends against eligible collateral; the Fed's counterparty is that central bank - correct
- The Federal Reserve, which lends directly to each domestic bank and takes their collateral itselfWhy not: The Fed's counterparty is the foreign central bank, not the individual banks.
- The domestic banks' depositors, through a bail-in of their depositsWhy not: Deposit bail-ins are not part of swap line operations.
- The US Treasury, because the dollars come from the US monetary baseWhy not: The Treasury is not the counterparty; the risk allocation rests with the foreign central bank.
The Fed is exposed to the foreign central bank, holding its currency, and that central bank decides to whom it lends and on what collateral. This division of credit risk lets the Fed lend without assessing foreign banks.
The hardest tier
After the Fed made dollar swap lines with several major central banks unlimited in October 2008, drawings rose to a peak in late 2008, and then, as markets recovered, fell during 2009 while the foreign exchange swap basis narrowed. Which interpretation best weighs the effectiveness of the response?
- Rising drawings show the lines failed, because banks had to rely on the central bank rather than on markets during the peakWhy not: High usage at the peak shows the lines supplied funding when markets had closed, not that they failed.
- Falling drawings in 2009 show that the underlying dollar mismatch of banks had been resolvedWhy not: Falling usage reflects market recovery and the lines' penalty pricing; the structural mismatch was not eliminated.
- The narrowing of the basis proves the swap lines had no effect, because drawings fell at the same timeWhy not: Falling drawings with a narrowing basis is consistent with a backstop effect: the lines' availability supports market pricing.
- The lines worked as a backstop that eased dollar strain; penalty pricing meant use fell as markets recovered - correct
Heavy use at the peak followed by lower use as the basis narrowed is the pattern of a successful backstop: it replaced the missing market during stress and was left as markets recovered. It did not fix the maturity and currency mismatch.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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