Foreign currency liquidity
Banking and Finance Law
The core principles of financial crisis management call upon central banks to lend freely, against good quality collateral, and at a penalty rate of interest, to solvent but illiquid banks and other financial institutions during periods of widespread panic and instability. While often taken for granted, these principles were designed for a world in which central banks have the capacity to create money denominated in the same currency as the one in which domestic banks and other financial institutions issue deposits and other short-term liabilities.
Unfortunately, this is not the world in which we live. The application of these principles is far from straightforward in a world where financial institutions rely on short-term foreign currency liabilities as a source of financing. This is the world of the Eurodollar market. The global financial crisis vividly illustrated the potential systemic risks arising from the existence of a large Eurodollar market. Faced with a systemic foreign currency liquidity crisis, central banks struggled to secure access to the foreign currency reserves needed to provide emergency liquidity assistance to their domestic banking systems. In response, the U.S. Federal Reserve and other major central banks established a network of swap lines designed to provide foreign currency liquidity assistance to the international financial system.
The central bank swap lines have been hailed as one of the most important and effective policy responses to the financial crisis. However, while it may be tempting to view them as an effective prophylactic against future foreign currency liquidity crises, the current structure of the swap lines fails to establish truly credible international commitments or constrain the moral hazard problems stemming from this ambitious state-sponsored liquidity insurance. This Article examines the unique policy challenges posed by foreign currency liquidity problems, along with how to build a more effective framework for the provision of foreign currency liquidity assistance.
Dan Awrey, "Brother, Can You Spare a Dollar? Designing an Effective Framework for Foreign Currency Liquidity Assistance," 2017 Columbia Business Law Review, 934 (2017)