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 these mechanisms. We identify a novel externality that arises under adverse selection and operates through the average quality of the assets traded, and three additional forces that shape the optimal policy under all pricing mechanisms: (i) the difference between the sellers' and buyers' ability to collect cash flow from the marginal unit traded, (ii) the sensitivity of the fire-sale price to the sellers' liquidity holdings, and (iii) incomplete risk sharing. Absent risk-sharing considerations and collateral constraints, the equilibrium is (Pareto) efficient under cash-in-the-market pricing; a liquidity requirement is optimal under second-best-use pricing; and a liquidity ceiling (i.e., a cap on liquid assets) is optimal under adverse selection. With inefficient risk sharing and collateral constraints, the socially optimal level of liquidity remains higher with second-best-use pricing compared to cash-in-the-market pricing, and a liquidity ceiling remains optimal with adverse selection.
Abstract: This paper investigates the financial stability consequences of banks' interest rate risk exposure and uninsured deposit funding share. We develop a model of heterogeneous banks, with a portfolio choice between interest rate-sensitive securities and credit-risky loans, a funding choice between insured and uninsured deposits, and endogenous run risk on uninsured deposits to jointly analyze banks' portfolio and funding fragility decisions. The model delivers the concentration of uninsured deposits in larger banks and the U-shaped relationship between the portfolio allocation to cash and securities and bank size. We study the effects of Federal Reserve rate hikes on banks and analyze micro-prudential policy tools to enhance the banking sector's resilience. Tightening a conventional capital requirement substantially lowers run risk and improves capital allocation but lowers the banking sector's ability to provide liquidity. A higher liquidity requirement targeting uninsured deposits reduces run risk at large banks but also causes misallocation in the lending market. A size-dependent capital requirement reduces run-risk by more than the liquidity requirement, with minimal unintended consequences.