I recently attended a very interesting presentation by William Allen, formerly of the Bank of England, on international liquidity.
Much of this concerned the use of central bank swap lines in response to the financial crisis. One of the immediate consequences of the collapse of Lehmans, was a substantial repatriation of short term cross-currency investment. For example, European banks had large short term dollar borrowings funding longer term dollar assets. The pressure on US money market funds led to a lot of this funding being pulled, leaving the banks trying to fund the gap. And although the Fed was providing liquidity in the US, the state of the interbank market meant that not much of that was finding its way to the foreign banks.
The interesting thing about this is that the liquidity crisis affecting banks in many countries was substantially taking place in a currency that was not their domestic one. And whilst a central bank's ability to provide liquidity support in its own currency is theoretically unlimited, that is not the case in a foreign currency. Central banks with large foreign reserve holdings may be able to cope. Otherwise, the central bank swap lines provide a way for them to get hold of the currency. Thus, to deal with the pressure on European banks post-Lehmans, the ECB exchanged euro for dollars with Fed, using the dollars to provide liquidity to the banks.
Nevertheless, it highlights an important issue when it comes to thinking about the role of banks in the economy. Many economists would consider that the health of the banking sector is an important factor in the state of the economy due to the consequences for the flow of credit to the non-financial sector. But even those models that attempt to incorporate some representation of banking tend to assume an essentially domestic operation. In reality, banking is very international. Over 50% of the assets of UK resident monetary financial institutions are denominated in currencies other than sterling (over 30% for those MFIs that are also UK owned)*. The implications for credit exposures are reasonably well understood as a result of global fallout from problems with US sub-prime. The implications for liquidity are perhaps less well known, but it raises important issues about the abilities of central banks to deal with bank runs. The monetary authority may exercise a high degree of control over its national currency, but not necessarily over its national jurisdiction.
Overall, there was good central bank co-operation in the crisis, which went a long way to preventing things getting even worse. However, cross-currency exposures of banks will remain an important risk issue going forward.
* Figures for November 2013. Source: Bank of England.