Central Bank to the World: Supplying Dollars in the COVID Crisis

In his comments at Jackson Hole last year, then-Bank of England Governor Mark Carney highlighted the continuing dominance of the U.S. dollar: it accounts for one-half of global trade invoicing; two thirds of emerging market external debt, official foreign exchange reserves, and global securities issuance; and nearly 90 percent of (one leg of) foreign exchange transactions.

It also is the basis for the Global Dollar system (see our earlier post). The BIS reports that short-term U.S. dollar liabilities of non-U.S. banks total $15 trillion. Foreign exchange forward contracts and swaps—with a gross notional value of more than $75 trillion—add substantially further to U.S. dollar exposures (see here). And, the U.S. Treasury reports that foreigners hold more than $7 trillion of U.S. Treasury securities. To put these numbers into perspective, total assets of U.S. depository institutions are currently $20 trillion. In other words, the U.S. dollar financial system outside of the United States is larger than the American banking system.

Like it or not, the Federal Reserve is the dollar lender of last resort not just for the United States, but for the entire world. The Fed’s role is not altruistic. Instead, it reflects the near-certainty that, in a world of massive cross-border capital flows, dollar funding shortages anywhere in the world will spill back into the United States through fire sales of dollar assets, a surge in the value of the dollar, increased domestic funding costs, or all three.

The Fed’s extraordinary efforts to counter the COVID-19 crisis include aggressive actions to counter dollar shortages outside the United States. In this post, we explore those actions, including the supply of dollar liquidity swaps to 14 central banks (“friends of the Fed”) and—to limit sales that might disrupt the Treasury market—the introduction of a repo facility to provide dollars to the others. We also note the challenges facing countries outside the small inner circle that do not have immediate access to the Fed’s swap lines….

Ten Years After Bear

Ten years ago this week, the run on Bear Stearns kicked off the second of three phases of the Great Financial Crisis (GFC) of 2007-2009. In an earlier post, we argued that the crisis began in earnest on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime mortgage debt. In that first phase of the crisis, the financial strains reflected a scramble for liquidity combined with doubts about the capital adequacy of a widening circle of intermediaries.

In responding to the run on Bear, the Federal Reserve transformed itself into a modern version of Bagehot’s lender of last resort (LOLR) directed at managing a pure liquidity crisis (see, for example, Madigan). Consequently, in the second phase of the GFC—in the period between Bear’s March 14 rescue and the September 15 failure of Lehman—the persistence of financial strains was, in our view, primarily an emerging solvency crisis. In the third phase, following Lehman’s collapse, the focus necessarily turned to recapitalization of the financial system—far beyond the role (or authority) of any LOLR.

In this post, we trace the evolution of the Federal Reserve during the period between Paribas and Bear, as it became a Bagehot LOLR. This sets the stage for a future analysis of the solvency issues that threatened to convert the GFC into another Great Depression.

Looking Back: The Financial Crisis Began 10 Years Ago This Week

In his memorable review of 21 books about the 2007-09 financial crisis, Andrew Lo evoked Kurosawa’s classic film, Rashomon, to characterize the remarkable differences between these crisis accounts. Not only were the interpretations in dispute, but the facts were as well: “Even its starting date is unclear. Should we mark its beginning at the crest of the U.S. housing bubble in mid-2006, or with the liquidity crunch in the shadow banking system in late 2007, or with the bankruptcy filing of Lehman Brothers and the ‘breaking of the buck’ by the Reserve Primary Fund in September 2008?”

In our view, the crisis began in earnest 10 years ago this week. On August 9, 2007, BNP Paribas announced that, because their fund managers could not value the assets in three mutual funds, they were suspending redemptions. With a decade’s worth of hindsight, we view this as a propitious moment to review both the precursors and the start of the worst financial crisis since the Great Depression of the 1930s.

But, first things first: What is a financial crisis? In our view, the term refers to a sudden, unanticipated shift from a reasonably healthy equilibrium—characterized by highly liquid financial markets, low risk premia, easily available credit, and low asset price volatility—to a very unhealthy one with precisely the opposite features. We use the term “equilibrium” to reflect a persistent state of financial conditions and note that—as was the case for Humpty Dumpty—it is easy to shift from a good financial state to a bad one, but very difficult to shift back again....

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Money, Banking, and Financial Markets