Abstract: We examine the unintended long-term consequences of the U.S.'s role as a dollar lender of last resort. Using administrative data, we show that dollar swap lines substitute for both market-based dollar funding and foreign central banks’ dollar reserves, especially when those sources are scarce. However, this backstop incentivizes global banks to take on greater currency mismatches while prompting foreign central banks to hold fewer dollar reserves, such as U.S. Treasuries. We develop a model that formalizes intermediated dollar lending of last resort, highlighting the global intermediation chain in emergency dollar provision. In the model, while swap lines help stabilize dollar appreciations and mitigate CIP deviations during times of stress, they lead to ex-ante over-investment (under-investment) in dollar assets by foreign private (central) banks due to pecuniary externalities. This inefficiency introduces unintended risks not only for foreign economies but also, perhaps surprisingly, for the U.S., by shifting Treasury holdings toward less stable investors and raising fire-sale risks.
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.
