Abstract: We study the feedback loop between dollar dominance, currency mismatch, and the U.S.'s role as a global dollar lender of last resort. Using new administrative data, we find that central bank swap lines act as substitutes for dollar reserves held by foreign central banks in helping fill global banks' dollar funding gaps, particularly when market-based synthetic dollar funding is scarce. U.S. dollar lending of last resort, however, incentivizes global banks to engage in greater currency mismatches while encouraging foreign central banks to hold relatively fewer dollar reserves, exacerbating dollar funding gaps during crises. We develop a model that incorporates swap lines into a framework of global banking and central banking, highlighting the intermediation chain in emergency dollar liquidity provision. Swap lines stabilize dollar funding markets during crises yet lead to ex-ante over-dependence on the dollar due to pecuniary externalities between global banks and foreign central banks. This dependence introduces unintended long-term risks, not only for foreign countries but also, perhaps surprisingly, for the U.S., as it alters Treasury holder composition and the heterogeneous exposure to fire sale risks. Finally, we examine how post-crisis regulations have inadvertently amplified the demand for a global dollar lender of last resort, creating a policy ratchet effect that entrenches systemic reliance on U.S. dollar liquidity backstop.
Abstract: We study liquidity requirements in a model of fire sales that nests three common pricing mechanisms—cash-in-the-market, second-best-use, and adverse selection—and can produce the same observables under each of these mechanisms. We identify three forces that shape the optimal policy. Absent risk-sharing considerations, the equilibrium is efficient with cash-in-the-market pricing; a liquidity requirement is optimal with second-best-use pricing; and a liquidity ceiling (i.e., a cap on liquid assets) is optimal with adverse selection. Accounting for risk-sharing considerations, the optimal level of liquidity remains higher with second-best-use pricing relative to cash-in-the-market pricing, and a liquidity ceiling remains optimal with adverse selection. Our results (i) provide a unifying theory of liquidity requirements applicable to a broad range of markets and asset classes, (ii) suggest that the mere possibility of fire sales is insufficient to justify liquidity requirements, and (iii) offer practical guidance for designing regulations governing intermediaries’ liquidity holdings.
Abstract: This paper investigates the financial stability consequences of banks' interest rate risk exposure and uninsured deposit funding share. We develop a model incorporating insured and uninsured deposits, interest rate-sensitive securities, and credit-risky loans to understand how banks respond to interest rate risk and the potential for deposit runs. The model delivers the concentration of uninsured deposits in larger banks and examines how banks' portfolio- and funding choices impact financial stability. When banks anticipate volatile bond returns, they seek exposure to this interest rate risk. We study the effects of recent Federal Reserve rate hikes on banks and analyze micro-prudential policy tools to enhance the banking sector's resilience. Higher liquidity requirements that target uninsured deposits are effective at curbing run risk of large banks, but cause misallocation in the lending market. Size-dependent capital requirements are equally effective at mitigating run risk, with minimal unintended consequences.
