Lenders of Last Resort and Global Liquidity: Rethinking the system

A dramatic indicator of the international scope of the crisis has been the direct extension of large-scale central bank credits to foreign central banks – in particular the Federal Reserve’s expansion of reciprocal swap lines with industrial-country and emerging-market central banks. In several cases, limits on the sizes of these swaps have been removed, allowing non-U.S. central banks such as the European Central Bank (ECB) and Swiss National Bank to supply financial markets with potentially unlimited quantities of dollars. Although limited Fed swap lines were created under the Bretton Woods system in 1962 and have existed in some form ever since, the recent expansion of such facilities represents an unprecedented delegation of the Fed’s powers to foreign policymakers. That development is a tacit admission that older notions of the LLR role, while suitable for an insular world characterized primarily by national finance, are ill suited to a twenty-first century environment of financial globalization.

 

What motivated these central-bank policy actions? The fundamental trigger was a by-product of the process of global deleveraging set off by the Lehman collapse: a shortage of hard-currency, especially dollar, liquidity in world financial markets. In turn, the dollar liquidity shortage – which has temporarily slowed the dollar’s long-run depreciation trend – has its roots in the international financial flows of the years 2003-07.

 

Over the 2000s the United States has run a series of historically large annual current-account deficits. Eastern Europe also ran large deficits (relative to GDP), as did several individual countries within the European Union, including Greece, Ireland, Portugal, and Spain. These deficits were naturally offset by surpluses elsewhere. Within the industrialized world, countries such as Japan, Germany, Norway, Sweden, and Switzerland had large surpluses. Within the set of emerging and developing economies, Asia (excluding Japan), the Middle East, and the Commonwealth of Independent States ran sizable surpluses while the Western Hemisphere and African countries did the same on a smaller scale.

 

While the causes of these imbalances remain a topic of active debate, a number of factors stand out. First, the 1997-98 Asian crisis clearly was followed by an enduring rise in saving investment balances throughout Asia. In some cases, countries maintained undervalued exchange rates and compressed demand to promote export-led growth, in the process accumulating large stocks of liquid international reserves, mainly dollars. One clear motive for reserve accumulation was to self insure against liquidity shocks rather than depend on the International Monetary Fund as in past crises. Whatever the causes—the details differ from country to country—a consequence of the increase in desired Asian surpluses was a downward pressure on world interest rates and price levels.

But it takes two to tango, and both policy as well as institutional responses in the industrialized world led to a significant magnification of the volume of world financial flows. The collapse of the dot-com bubble, followed by the 9/11 attacks, led the Federal Reserve and other central banks to lower interest rates. Japan remained in the grip of a seemingly intractable deflation. Discerning a similar potential in the U.S. economy, the Fed held interest rates quite low until embarking on a gradual tightening cycle in mid-2004. Low industrial-country interest rates helped to inflate commodity prices, notably the price of oil, helping to fuel the increased Russian, Middle Eastern, and Latin American external surpluses. This international income transfer that may have put further downward pressure on world interest rates, as during the oil boom of the 1970s, which was prologue to the 1980s debt crisis.

Low interest rates and booming commodity prices during themid-2000s contributed to a prolonged period of tranquility or emerging markets. Many began to question the ongoing need for the International Monetary Fund (IMF), as that institution shrank under pressure of reduced lending revenues. As is now evident, however, emerging markets were benefiting from an exceptionally favorable but temporary constellation of external forces.

Finally, low interest rates had a dramatic effect on real estate prices. Low interest rates and the availability of cheap foreign finance, interacting with distortions in markets for housing finance, fueled dramatic house-price appreciation. Higher levels of housing equity eased households’ liquidity constraints and supported high consumption levels and reduced levels of private saving out of GDP. While similar effects were seen in many other countries—there is a high statistical correlation over the 2000s between real estate appreciation and current account deficits—the United States was the epicenter of the financial innovations and practices that sparked the collapse of 2007-08. This fact led to one of the ironies of the financial crisis: although several analysts had worried up until 2007 that a U.S. housing collapse might signal a compression of the U.S. external deficit and a collapse in the dollar’s value, the housing collapse, at several stages of the crisis, actually led to an apparent shortage of dollars.

The European banks and the dollar

One reason for the dollar shortage starting in August 2007 was European banks’ high propensity to invest in U.S. dollar assets over 2003-07. Initially around $4 trillion in 2003, European banks’ U.S. dollar assets exceeded $8 trillion by the first quarter of 2007.2 These banks drew short-term dollar funding from the interbank market, and also borrowed nondollar currencies, swapping these funds into dollars on a short-term basis, to hedge their long dollar positions.

European banking flows into the U.S. were invested heavily in AAA-rated tranches of securitized assets such as subprime mortgage pools. The high credit ratings of these structured products reflected low expected loss, but ignored portfolio risk. In fact, the assets carried significant systematic risk due to the likelihood of default precisely when all global asset markets would be melting down simultaneously. In addition to expected return, these structured products carried an important collateral benefit. By holding them instead of assets subject to idiosyncratic risk and therefore with lower credit ratings, banks were able to reduce required regulatory capital ratios. The result was regulatory arbitrage on a large scale.

European banks’ need to fund their U.S. purchases through short-term dollar borrowing made them susceptible to any reduced availability of dollar liquidity. This is what happened in August 2007, and even more dramatically in September 2008. Interbank markets seized up, foreign exchange swap markets became illiquid, and U.S. money-market funds faced a run in the fall of 2008 and retracted their foreign dollar lending.

Central-bank withdrawals during 2007-08 of dollar reserves that had been placed in commercial banks didn’t help. On top of funding illiquidity, banks faced market illiquidity as they attempted to sell their toxic assets.

The ECB initially had the tools to provide euro liquidity, but not dollar liquidity. European institutions needing dollars, but lacking access to the Fed through U.S. affiliates, sold euros for dollars on the foreign exchange market. The result of these aggregate sales was upward pressure on the dollar and a relatively weaker euro. As a response, the central bank swap arrangements for dollars were set up starting in December 2007.

Since that date the Fed has acted as a global LLR for dollars. It has done so by subcontracting its LLR function (along with its monopoly on money creation) to a selected set of foreign central banks. These arrangements have been ad hoc and explicitly temporary.

Most likely, more limited swap facilities will be maintained into the future—as in the past—with the option (at the currency issuer’s discretion) for greater flexibility in times of crisis. To the extent that nondollar currencies such as the euro and (eventually) the renminbi could be in short supply during future financial breakdowns, there is a strong case for crisis-elastic sources of those currencies as well. Even the central banks and treasuries of industrial countries may choose to accumulate larger stocks of liquid foreign-currency reserves, easily available for lending during episodes of turbulence.

The systematic approach

One important lesson of the crisis, however, is the need to take a systemic view of measures aimed at financial stability. As numerous observers of the recent crisis have noted, measures that enhance the stability of a single institution, viewed in isolation, could be inimical to the stability of the financial system as a whole. There is a fallacy of composition, for example, in asking financial institutions to augment their capital asset ratios in a crisis: a fire-sale externality could destabilize all institutions as each one scrambles to unload assets in illiquid markets.

A similar point applies to national efforts to self-insure through increased holdings of liquid international reserves: when a country draws down its dollar reserves held abroad, that action might well have price or liquidity effects that increase financial instability abroad. This is a familiar theme from time honored textbook examples of coordination failures in reserve management ranging from the scramble for gold in the interwar years to the Triffin problem. But the basic insight remains relevant, in a different form, today. The implication is that the world economy needs lenders of last resort capable of creating and providing true outside liquidity.

The enhanced swap lines provided by the Fed starting in 2007 were indeed a source of outside dollar liquidity. Going forward, however, it seems impractical and politically problematic for national central banks to subcontract emergency lending over the long term on what is essentially a bilateral basis. A more efficient solution would centralize last-resort lending of foreign currencies in an institution whose operations would ideally approximate the outcome of a cooperative equilibrium among policymakers.

The practical obstacles to designing and establishing such an institution, ranging from the need for broad international political support to the limitation of moral hazard, are daunting. To start, an international LLR, if not endowed with supranational regulatory powers itself, would at least need ready access to accurate, up-to-date, and internationally consistent data on the health of member countries’ financial sectors. It is inadvisable for any LLR to delegate its functions blindly. The current difficulty of agreeing an enhanced regulatory framework even among European Union countries offers a sobering counterpoint on the possibilities for even broader international regulatory cooperation. Nonetheless, the need for progress is urgent.

At the moment, the International Monetary Fund—itself the improbable product of a visionary postwar exercise in international political cooperation—is the closest thing we have to an international LLR.7 The IMF has the capacity not only to create outside liquidity, but also to channel inside liquidity agents with relatively ample liquidity to markets in which liquidity is scarce. IMF quotas represent outside liquidity. When Pakistan borrows dollars from the IMF, for example, the dollars come from an IMF account at the Federal Reserve. If the IMF borrows dollars from the government of Japan’s reserves, however, liquidity may simply be reallocated, not created. In a crisis situation, even such liquidity reallocation by the Fund can help stave off economic disaster for the borrower. A major structural advantage of the IMF is that it can create liquidity in alternative national monies, thereby meeting potential shortages of nondollar currencies.

In recent decades the IMF has intervened almost exclusively with emerging and developing countries. It seems likely that for some time, the IMF will continue to focus on the group of less prosperous countries, with the LLR needs of richer countries met through ad hoc bilateral or even multilateral arrangements of the type seen recently. It is not inconceivable, however, that the IMF’s role could someday extend, as in the past, to the richer countries. Indeed, this development seems natural in a world where the current emerging economies are evolving toward eventual economic and political parity with the current group of industrial economies.

Enhancing the IMF’s lending capacity has rightfully been high on the agenda of policymakers seeking to address the global financial crisis. Equally important, however, have been moves to reform the political governance of the IMF in a way that recognizes the increasing importance of the developing countries in the world economy. Much remains to be done, especially in the sphere of international regulatory reform, and the difficulties cannot be overstated. Nonetheless, the recent global financial crisis has underlined both the importance and the nontraditional nature of the lender-of-last resort function in a financially globalized world characterized by multiple national currencies. As the twenty-first century unfolds, the IMF seems certain to be an increasingly important player in performing that function.

Maurice Obstfeld is Professor of Economics at the University of California, Berkeley.

Download the PDF (875KB) to view all images, graphs and additional information.