The massive public sector support for banks and other financial institutions during the global financial crisis has understandably attracted a maelstrom of controversy. One of the most controversial aspects of this support was its extension to financial institutions incorporated and licensed in other countries. In the US, 19 of the 25 largest borrowers under the emergency Term Auction Facility were European banks. European banks were also the recipients of billions of dollars as part of the Federal Reserve Bank of New York’s bailout of AIG. And perhaps most strikingly, the Federal Reserve extended over $USD500 billion at its peak to foreign financial institutions under temporary swap lines with other major central banks.
This extraordinary public support for foreign financial institutions is often defended as having been necessitated by the high level of integration and interconnectedness within the global financial system. One of the primary drivers of this integration and interconnectedness stems from the dominant role of the US dollar in international trade, finance, and investment. At the heart of this role is an important yet relatively obscure corner of the financial system known as the ‘Eurodollar’ market.
The Eurodollar market has been around for a very long time. Yet it is only in the past quarter century that this market has blossomed into a multi-trillion dollar behemoth, the health of which has a significant impact on global economic activity and financial stability. The best known Eurodollar market is the market for US dollar deposits held with foreign banks in countries like the UK. However, there are also significant Eurodollar markets for commercial paper, repo agreements, derivatives, and trade financing.
The most striking feature of the Eurodollar market is that it revolves around the issuance of short-term liabilities by financial institutions that are not licensed and subject to prudential regulatory oversight in the country that issues the currency in which these liabilities are denominated. As a result, these institutions do not enjoy access to the emergency liquidity assistance (‘ELA’) facilities provided by the central bank in that country. These ELA facilities are an essential tool of financial crisis management: providing loans to solvent but illiquid financial institutions in the event that private sources of financing become unavailable. While financial institutions issuing Eurodollar liabilities may have access to the ELA facilities provided by the central bank in their home country, there is no guarantee that this central bank will have access to sufficient reserves of the required foreign currency. This leaves these financial institutions heavily reliant on private markets as a source of foreign currency liquidity. When these markets break down, these institutions run the risk of finding themselves without a port in the middle of a dangerous storm.
This fault line in the global crisis management architecture leaves the financial institutions that issue Eurodollar liabilities vulnerable to liquidity shocks of the variety experienced during the global financial crisis. One of the most pernicious episodes of the financial crisis was the international US dollar liquidity shortage that reached its apex in the autumn of 2008. This shortage forced foreign financial institutions that relied on the Eurodollar market to either cut back on their US dollar lending activities or sell dollar denominated assets. The shortage thus contributed to the broader contraction of lending and fire sale dynamics that fanned the flames of the crisis. Ultimately, it was the desire to extinguish these flames that motivated the Federal Reserve to provide such extraordinary support to foreign financial institutions.
This paper examines two intertwined policy challenges arising from the existence of a large Eurodollar market. The first stems from the prospect of destabilizing cross-border capital flows as foreign currency liquidity is withdrawn from the international financial system during periods of financial instability. The second stems from the practical constraints on the ability of central banks to respond to this withdrawal by providing financial institutions with ELA denominated in foreign currencies. These challenges generate enormous risks for the financial institutions that issue Eurodollar liabilities, for the countries that these institutions call home and, ultimately, for global financial stability.
Having framed these challenges, the paper examines a range of potential policy responses At one end of the spectrum is a blanket prohibition against the issuance of Eurodollar liabilities. At the other, the creation of a global currency and central bank. In between reside a number of reforms to the emerging institutional architecture for the provision of foreign currency liquidity assistance (‘FCLA’). This architecture includes the central bank swap lines used to provide US dollar liquidity in the thick of the financial crisis, along with the new and untested emergency lending facilities recently introduced by the IMF. In the case of the swap lines, these reforms include the introduction of more observable and objective conditions for the provision of FCLA, ex ante qualifications for eligible countries, regulatory constraints for eligible financial institutions, and a fee structure that better reflects the role of FCLA as a form of insurance. In the case of the IMF’s new emergency lending facilities, these reforms include a significant expansion of the available financial resources and the imposition of targeted ex post monitoring on recipient countries. Collectively, these reforms would help constrain the build-up of risk within the Eurodollar market and ameliorate the potential moral hazard problems associated with this ambitious state-sponsored liquidity support.
This paper makes two contributions to the literature examining the sources of financial instability and the theory and practice of international financial crisis management. First, it describes the important roles that the modern Eurodollar market plays within the international financial system. While a great deal has been written about the Eurodollar market, the existing literature explores questions around its role as a vehicle for regulatory arbitrage and whether its growth contributes to the aggregate money supply and, thus, inflation. With some notable exceptions, this literature also has a tendency to describe the Eurodollar market at a high level of abstraction, thereby contributing to the considerable degree of confusion around what the Eurodollar market is, how it works, and why it is so important. In sharp contrast, this paper provides a more detailed description of the mechanics of various components of the Eurodollar market and examines how they can contribute to financial instability. Second, this paper identifies the challenges that a large Eurodollar market poses in terms of effective international financial crisis management. It then identifies and evaluates the relative merits of various alternatives for how we might go about addressing these challenges with the objective of promoting greater global financial stability.
This blog post is based on my paper “Brother, Can You Spare a Dollar? Designing an Effective Framework for Foreign Currency Liquidity Assistance”, the full text of which is available here.
Dan Awrey is an Associate Professor of Law and Finance at the Law Faculty of the University of Oxford and a Fellow of Linacre College.