Central Bank Dollar Swap Lines and Overseas Dollar Funding Costs

Abstract

Listen

Translate article

1. INTRODUCTION In the decade prior to the financial crisis, the dollar-denominated assets of foreign banks, especially institutions in Europe, increased dramatically. But with the onset of the crisis in 2007, these banks saw their access to dollar funding come under tremendous stress--with potentially dire consequences for financial markets and real activity associated with banking. The progression of market stresses led the Federal Reserve in December 2007 to establish central bank (CB) dollar swaps: reciprocal currency arrangements with several foreign central banks that were designed to ameliorate dollar funding stresses overseas. These arrangements expanded as the crisis continued throughout 2008 and they remained in place through the end of 2009, becoming an important part of global policy cooperation. In this article, we provide an overview of the CB dollar swap facilities, discuss the changes in breadth and volume as funding conditions (both in the market and through the facilities) evolved, and assess the economic research documenting the efficacy of the swaps. We conclude that the CB dollar swap facilities are an important tool for dealing with or minimizing systemic liquidity disruptions, as demonstrated in the reintroduction of the swaps in May 2010. We begin in Section 2 by describing the dollar funding needs of foreign banks and examining the private cost of dollars before, during, and after the crisis. Two measures are used to show the increased cost of dollar funds in private markets during the crisis. The first is the spread between the London interbank offered rate (Libor) and the overnight index swap (OIS) rate. The second measure is the foreign exchange (FX) swap implied basis spread, which reflects the cost of funding dollar positions by borrowing foreign currency and converting it into dollars through an FX swap. Additional evidence of disruptions to dollar markets is drawn from the intraday federal funds market. We compare the average price of federal funds during hours with the average price during afternoon trading. The differential in cost was normally close to zero in the precrisis period through August 2007 and thereafter evolved to reflect a substantial paid for federal funds acquired in trading. This morning premium persisted through December 2008, reaching elevated levels following the bankruptcy of Lehman Brothers. Among the explanations is the view that this spread can be interpreted partially as a premium that evolved over the course of the crisis as a result of dollar demand by European banks lacking a natural dollar deposit base for meeting dollar funding needs. In Section 3, we provide a history of the CB dollar swap facilities. After starting in 2007, the Federal Reserve's program for providing dollars to foreign markets evolved extensively with respect to both the number of countries with swap agreements and the amount of dollars made available abroad. The tenor of funds made available through the dollar auctions also evolved over time, increasing from up to one month The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. initially to up to three months six months later, ultimately returning to primarily shorter tenors. At the program's peak, longer term swaps dominated the total amount outstanding. Net dollars outstanding through the CB dollar swaps peaked at nearly $600 billion toward the end of 2008, as banks hoarded liquidity over year-end, although some of this demand for dollars began to unwind following year-end. Amounts outstanding at the dollar swap facilities declined to less than $100 billion by June 2009, to less than $35 billion outstanding by October 2009, and to less than $1 billion by the time the program expired on February 1, 2010. (1) In Section 4, we show the differential costs of accessing dollars at the official liquidity facilities, with the effective all-in cost of dollars at the various central banks deriving from the specific facility designs and collateral policies. …