## CHAPTER 5 BANkS’ DOLLAR FuNDING: A SOuRCE OF FINANCIAL VuLNERABILITY

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### Introduction and historical role of the US dollar
- The US dollar "historically has played a prominent role in global trade and financial flows."
- In the run-up to the global financial crisis, European banks accumulated sizable US dollar assets financed mainly in short-term wholesale funding markets such as repo, commercial paper, and certificates of deposits.
- When US wholesale funding markets became impaired in 2007–08, non-US banks tapped the foreign exchange swap market to convert other currencies into US dollar funding, propagating stress through that market.
- The freeze-up of US dollar wholesale funding markets required international provision of dollar liquidity via central bank swap lines, where the US Federal Reserve provided US dollars to some non-US central banks.

### Post-crisis persistence and composition of US dollar intermediation
- Non-US banks—especially those from advanced economies—remain significant intermediaries of US dollar transactions.
- Key figures on US dollar–denominated assets of non-US banks:
  - "more than $12 trillion" compared with "$10 trillion" just before the onset of the crisis.
  - Increased from "$9.7 trillion in 2012 to $12.4 trillion by early 2018."
- Provider composition shifts:
  - European banks reduced their share as they deleveraged.
  - Japanese banks and Canadian banks greatly increased their US dollar–denominated claims.
- Geographic presence:
  - Positions held at US branches surpass 10 percent in 15 of the 26 economies examined and can be as high as 40 to 50 percent for some economies.
  - Positions at US subsidiaries tend to be much smaller, except in a handful of cases.

### Benefits and vulnerabilities of non‑US bank dollar intermediation
- Benefits:
  - Efficient allocation of liquidity on a global scale.
  - Facilitation of financing flows to emerging markets.
- Vulnerabilities and constraints:
  - Stable US dollar deposits outside the United States are insufficient to fund all global US dollar credit by non-US banks.
  - US regulation confines the use of US-based subsidiary deposits to US activities.
  - Other available sources—US branches and international wholesale markets—are mostly wholesale, short term, and volatile, presenting sizable refinancing risk in stress.
  - Foreign exchange swaps are usually costlier and are the "marginal" source of US dollar funding.

### Structural changes, regulation, and funding-market implications
- Reliance on foreign exchange swaps continues; structural changes have made funding more prone to instability.
- Increasing role of nonbanks in foreign exchange derivatives provision; commitments in stress are untested.
- Postcrisis regulatory and jurisdictional effects:
  - Global capital and liquidity requirements and jurisdictional rules may have reduced US dollar funding supply to non-US banks.
  - The 2016 money market mutual fund reform in the United States reduced access to US dollar funding for non-US banks, increasing reliance on foreign exchange swaps despite a rise in offshore US dollar deposits.
  - Supervisory and regulatory tightening complicated cross-border liquidity management at global financial institutions.
- Result: higher costs across wholesale US dollar funding markets, most noticeably in the foreign exchange swap market.

### Indicators of US dollar funding fragility (constructed in chapter)
- Indicators developed:
  - cross-currency funding gap (difference between US dollar–denominated assets and liabilities),
  - cross-currency funding ratio (gap relative to assets),
  - US dollar liquidity ratio (analogous to liquidity coverage ratio; US dollar HQLA versus one-month net cash outflows),
  - US dollar stable funding ratio (in the spirit of net stable funding ratio).
- Key statistics:
  - Cross-currency funding gap: after falling from a mid-2008 peak of "$1 trillion (or 10 percent of US dollar assets)", the gap has been increasing, "exceeding $1.4 trillion"; corresponds to a cross-currency funding ratio of "13 percent of US dollar assets."
  - Of the 26 economies, 17 had positive funding gaps as of the first quarter of 2018; in economies with positive gaps, the gaps totaled "$1.8 trillion—18 percent of US dollar–denominated assets."
  - Almost all of the 26 economies experienced an increase in their gap since 2012.
  - US dollar liquidity (measured for a subset of 14 economies) has been increasing steadily since the global financial crisis, primarily reflecting an increase in US dollar HQLA, but remains below overall banking-system liquidity measured across all currencies.
  - US dollar stable funding ratio has improved only moderately since the global financial crisis.

### Measuring US dollar funding costs: the cross‑currency basis
- Cross-currency basis definition and measurement:
  - Calculated as the difference between the cost of funding US dollars directly from the cash market and the synthetic US dollar interest rate obtained when funding in a different currency and swapping that currency into US dollars.
  - Funding costs in each currency are measured using the relevant London interbank offered rate at one- and three‑month tenors.
  - Throughout the chapter, "increase in US dollar funding cost" means widening of the cross‑currency basis; that is, it becomes more negative (exception: Australia, which has a persistently positive cross‑currency basis).
- Sample period for empirical analysis: "January 1, 2000, to March 1, 2018."

### Drivers of the cross‑currency basis and amplification by funding fragility
- Supply-side drivers:
  - LIBOR-OIS spread, bid-ask spread (transaction costs), impaired interbank funding markets.
- Demand-side drivers:
  - default probability of the banking sector in the home economy, term spread differential (home economy interest margin relative to the United States), FX implied volatility, US dollar index, VIX.
- Market-sentiment effect: rising VIX can alleviate pressure on the basis by dampening demand for risky US dollar investments.
- Amplification by the cross-currency funding ratio (CCFR):
  - When CCFR is high (fourth quintile) a given shock (e.g., an increase in implied FX volatility) produces a larger widening of the cross‑currency basis—"on the order of 50 percent larger"—relative to when CCFR is low (first quintile).
- Regulatory timing effects:
  - Since "January 1, 2015" quarter‑end spikes in balance-sheet expansion costs have caused jumps in the basis, affecting the one‑month basis more than the three‑month basis.
  - Financial regulatory changes noted: stressed VaR (2013), supplementary leverage ratio (2014), liquidity coverage ratio (2015), US money market mutual fund reform (2016).
  - The 2016 US money market mutual fund reform is associated with a sharp widening of the basis due to draining of funds out of prime institutional money market funds.
  - Introduction of liquidity coverage ratio and other postcrisis regulations constrained US banks’ ability to supply foreign exchange swaps, strengthening the association between CCFR and the basis.

### Financial‑stress implications of tightening US dollar funding (quantified)
- A 50 basis point increase in the cross‑currency basis (described as the average quarterly change at onset of the global financial crisis) is associated with:
  - a 0.22 standard deviation increase in the probability of banking sector default (equivalent to a "7½ percent increase"),
  - an additional tightening of domestic financial conditions by "0.29 standard deviation."
- Nonlinear and historical prominence:
  - Relationship is nonlinear and stronger for large increases in the basis, with prominence during the global financial crisis and the 2011 US money market fund run on European banks.
- Spillovers to recipient economies:
  - A 50 basis point increase in the funding costs of a recipient economy’s main lenders results in a "0.1 standard deviation increase in the probability of default of the recipient’s banking sector (equivalent to a 3.3 percent increase)."
  - Spillovers are quantitatively stronger and statistically significant for the top 10 US dollar cross‑border recipients.

### Cross‑border lending channel, quantified lending responses, and substitution limits
- Cross‑border lending is the main transmission channel of increased US dollar funding costs to recipient economies.
- Lending responses to a 50 basis point annual cumulative increase in US dollar funding costs:
  - Reduction in US dollar cross‑border lending by "5.3 percent."
  - When the lender is an emerging market: "7.1 percent decrease in cross‑border lending to all recipients" and "9.3 percent decrease in lending to other emerging markets."
  - Emerging market recipients: a 50 basis point increase affects US dollar lending to emerging market recipients by "about –6.6 percent" (about twice the effect on advanced economy recipients).
- Substitution capacity of recipients:
  - An average recipient can compensate for only about "half" of a lender’s cutback by increasing US dollar borrowing from other lenders.
  - Emerging market recipients can compensate for only about "one‑quarter" of the loss.
  - If US dollar funding conditions tighten across a recipient economy’s foreign lending partners, domestic banks can compensate for only "20 percent" of the decline in US dollar credit.
  - Borrowing in other currencies does not substitute; cross‑border borrowing in other currencies falls by "one‑third" of the initial cutback.
  - Emerging market recipients show even less ability to compensate.

### Amplification by US dollar activities and funding fragility
- Home economies with greater bank exposure to US dollar activities (share of US dollar assets to total assets) experience amplified adverse impacts from increases in US dollar funding costs.
- Cross‑currency funding ratio and measures of US dollar funding fragility strengthen transmission from higher US dollar funding costs to home‑economy financial stress and to reductions in cross‑border lending.

### Subsidiary‑branch mix, foreign presence, and heterogeneity of effects
- Dollar liquidity held at US subsidiaries cannot be easily transferred to the parent and does not significantly mitigate home economy financial stress induced by tightening US dollar funding.
- Foreign banking presence:
  - High share of foreign subsidiaries in the home economy does not have a significant amplification effect.
  - High share of foreign branches in the home economy is estimated to exacerbate stresses: home economies with substantial foreign branch presence experience an increase in financial system stress of "0.64 standard deviations (21 percent)" in response to tightening US dollar funding.

### Mitigating factors: bank health, swap lines, reserves
- Stronger home economy bank health mitigates transmission:
  - Low capital ratio (first quintile): a 50 basis point increase leads to "0.40 standard deviations (14 percentage points)" increase in probability of default.
  - High capital ratio (fourth quintile): impact decreases to "0.25 standard deviations (an 8 percent increase)."
  - Greater overall liquidity (ratio of cash to assets) and higher profitability (return on assets) show similar mitigating benefits.
- Swap arrangements with the Federal Reserve:
  - Swap arrangements limit deviation from covered interest parity by offering alternative US dollar funding and curb funding risk.
  - Historical usage: temporary US dollar liquidity swap arrangements began in "December 2007"; number of central banks engaging peaked at "14 in October 2008" and stabilized to "five major advanced economy central banks in May 2010 with full allotment."
  - Event: Federal Reserve’s unexpected announcement on "November 30, 2011" lowering the swap line rate by "0.5 percent" was associated with narrowing of daily cross‑currency bases for currencies with swap arrangements.
  - Regression evidence: in economies with Federal Reserve swap arrangements there was no statistically significant association between change in US dollar funding conditions and change in domestic financial stress; without swap lines the association was statistically significant.
- International reserves:
  - Non‑US central banks’ international reserve holdings can mitigate US dollar liquidity tightening by providing contingent US dollar liquidity to the domestic financial system.
  - Empirical quantifications:
    - With US dollar liquidity at its historical median, a 50 basis point increase in US dollar funding costs results in "0.38 standard deviation" increase in an economy with high reserve holdings (fourth quintile), compared with a "1.22 standard deviation" increase when reserve holdings are low (first quintile).
    - Facing similar funding cost increases, economies with a swap line arrangement do not reduce lending significantly, whereas those without a swap line arrangement with the Federal Reserve provide "about 3.2 percent less" cross‑border US dollar lending.
    - In economies with high international reserves (top quintile), cutbacks in lending are about "40 percent less" than in those with low (bottom quintile) reserve holdings.

### Policy implications and recommended monitoring tools
- The chapter emphasizes trade-offs:
  - Postcrisis regulatory reforms may have had unintended consequences in global US dollar funding markets, but the chapter does not recommend rolling back regulatory reforms.
  - Trade‑offs exist between risk abatement and reduction in financial intermediation activity, and between public provision of liquidity buffers and ex ante incentives to take excessive risk (moral hazard).
- Monitoring and preparedness:
  - Regulators should monitor US dollar funding fragility of local banks and develop or enhance currency‑specific liquidity risk frameworks, including stress tests, emergency funding strategies, and resolution planning.
  - The cross‑currency funding ratio, liquidity ratio, and stable funding ratio (SFR) are useful monitoring tools as used in this chapter.
- Benefits of access to US dollar liquidity during stress:
  - International reserves can play a stabilizing role and should be considered in reserve adequacy assessments.
  - Access to US dollar liquidity through swap lines can contribute to stability, including via a signaling effect.
  - There is a case for a stronger global financial safety net, including through adequate IMF resources, such as those provided through flexible credit lines.

*Source: International Monetary Fund | October 2019 — Chapter 5.*

### Introduction

### Introduction

### Historical role of the US dollar in global finance
- The US dollar "historically has played a prominent role in global trade and financial flows."
- In the run-up to the global financial crisis, European banks accumulated sizable US dollar assets financed mainly in short-term wholesale funding markets such as repo, commercial paper, and certificates of deposits.
- When US wholesale funding markets became impaired in 2007–08, non-US banks tapped the foreign exchange swap market to convert other currencies into US dollar funding, propagating stress through that market.
- The freeze-up of US dollar wholesale funding markets required international provision of dollar liquidity via central bank swap lines, where the US Federal Reserve provided US dollars to some non-US central banks.

### Post-crisis persistence and composition of US dollar intermediation
- A decade after the crisis, the US dollar "still plays a key role in international banking," with non-US banks—especially those from advanced economies—remaining significant intermediaries of US dollar transactions.
- US dollar–denominated assets of non-US banks amount to more than $12 trillion, compared with $10 trillion just before the onset of the crisis.
- US dollar–denominated assets of global non-US banks increased from $9.7 trillion in 2012 to $12.4 trillion by early 2018.
- Among major providers of US dollar credit:
  - European banks reduced their share as they deleveraged following the global financial crisis and the euro area crisis.
  - Japanese banks and Canadian banks have greatly increased their US dollar–denominated claims.
- A significant portion of US dollar assets is located in branches and subsidiaries in the United States; shares in the aggregate have remained relatively stable over time.
  - Positions held at US branches surpass 10 percent in 15 of the 26 economies examined and can be as high as 40 to 50 percent for some economies.
  - Positions at US subsidiaries tend to be much smaller, except in a handful of cases.

### Benefits and vulnerabilities of non-US bank intermediation in US dollars
- Benefits:
  - Efficient allocation of liquidity on a global scale.
  - Facilitation of financing flows to emerging markets.
- Vulnerabilities:
  - Stable US dollar deposits outside the United States are insufficient to fund all global US dollar credit by non-US banks.
  - US regulation confines the use of US-based subsidiary deposits to US activities, limiting deployment globally.
  - Other available sources—US branches and international wholesale markets—are mostly wholesale, short term, and volatile, presenting sizable refinancing risk in stress.
  - Foreign exchange swaps are usually costlier and are the "marginal" source of US dollar funding, used to fill remaining gaps.

### Structural changes in funding markets and regulatory impacts
- Reliance on foreign exchange swaps continues; structural changes have made funding more prone to instability.
- The role of nonbanks in foreign exchange derivatives provision is increasing; nonbanks' commitment in stress scenarios is untested.
- Postcrisis regulatory reforms and jurisdictional rules may have tightened the supply of US dollar funding to non-US banks:
  - Global capital and liquidity requirements and specific regulations at the individual jurisdiction level may have reduced US dollar funding supply to non-US banks.
  - The 2016 money market mutual fund reform in the United States reduced access to US dollar funding for non-US banks, increasing reliance on foreign exchange swaps despite a rise in offshore US dollar deposits.
  - Supervisory and regulatory tightening may have complicated cross-border liquidity management at global financial institutions.
- These structural changes have resulted in higher costs across wholesale US dollar funding markets, most noticeably in the foreign exchange swap market.

### Funding fragility: indicators and recent developments
- The chapter constructs several indicators of US dollar funding fragility for non-US banks: the cross-currency funding gap, the cross-currency funding ratio, a US dollar liquidity ratio, and a US dollar stable funding ratio.
- Cross-currency funding gap and ratio:
  - The cross-currency funding gap is defined as the difference between US dollar–denominated assets and liabilities.
  - After falling from a mid-2008 peak of $1 trillion (or 10 percent of US dollar assets), the cross-currency funding gap has been increasing in recent years, exceeding $1.4 trillion; this corresponds to a cross-currency funding ratio of 13 percent of US dollar assets.
  - Of the 26 economies, 17 had positive funding gaps as of the first quarter of 2018; in economies with positive gaps, the gaps totaled $1.8 trillion—18 percent of US dollar–denominated assets.
  - Almost all of the 26 economies experienced an increase in their gap since 2012.
- US dollar liquidity ratio (constructed analogously to the regulatory liquidity coverage ratio):
  - Focuses on holdings of US dollar high-quality liquid assets (HQLA) and US dollar net cash outflows likely during a one-month stress scenario.
  - US dollar liquidity of non-US banks has been increasing steadily since the global financial crisis, primarily reflecting an increase in US dollar HQLA.
  - Measures were constructed for a subset of 14 economies because of data limitations.
  - Despite improvements, US dollar liquidity remains below the overall liquidity of banking systems measured across all currencies.
- US dollar stable funding ratio (constructed in the spirit of the net stable funding ratio):
  - Reflects banks' ability to fund US dollar assets over a longer time horizon using stable sources.
  - The US dollar stable funding ratio has improved only moderately since the global financial crisis, with little change among components.

### Measuring US dollar funding costs: the cross-currency basis
- The chapter uses the US dollar cross-currency basis as the measure of US dollar funding costs for non-US banks.
- Definition:
  - The cross-currency basis is calculated as the difference between the cost of funding US dollars directly from the cash market and the synthetic US dollar interest rate obtained when funding in a different currency and swapping that currency into US dollars.
  - A positive (negative) currency basis implies that the direct dollar cost is higher (lower) than the synthetic one.
- Operational details:
  - Funding costs in each currency are measured using the relevant London interbank offered rate at one- and three-month tenors.
  - Throughout the chapter, reference to an "increase in US dollar funding cost" means widening of the cross-currency basis; that is, it becomes more negative. (An exception is Australia, which has a persistently positive cross-currency basis.)
- The chapter notes that changes in macroeconomic conditions in either the United States or in home economies could lead to future stress in US dollar funding markets.

### Analytical objectives and empirical approach
- The chapter investigates:
  1. How the cost of US dollar funding responds to different drivers of supply and demand identified in the literature.
  2. How tighter US dollar funding conditions may generate financial stress in the home economies of non-US global banks.
  3. To what extent tightening could lead to cutbacks in the cross-border supply of US dollar–denominated lending from home economies to recipient economies.
- For all three issues, the econometric analysis highlights the amplifying or mitigating role of US dollar funding fragility, macroeconomic conditions, and policy-related factors.
- The econometric approach is described in detail in Online Annex 5.2.

*Source: International Monetary Fund | October 2019 — Chapter 5: Introduction.*

### CHAPTER 5 BANkS’ DOLLAR FuNDING: A SOuRCE OF FINANCIAL VuLNERABILITY

### CHAPTER 5 BANkS’ DOLLAR FuNDING: A SOuRCE OF FINANCIAL VuLNERABILITY

### Cross-currency basis: behavior and drivers
- Pre-global financial crisis: the cross-currency basis was close to zero, consistent with covered interest parity.
- Post-global financial crisis: covered interest parity deviations emerged; the basis became large and negative for many currencies and has not fully reverted to zero.
- Sample period cited for empirical analysis: January 1, 2000, to March 1, 2018.
- Key demand- and supply-side drivers of the cross-currency basis:
  - Supply-side: LIBOR-OIS spread (spread between the London interbank offered rate and the overnight index swap rate), bid-ask spread (transaction costs), impaired interbank funding markets.
  - Demand-side: default probability of the banking sector in the home economy, term spread differential (home economy interest margin relative to the United States), FX implied volatility, US dollar index, VIX (Chicago Board Options Exchange Volatility Index).
- Market sentiment in the United States (rising VIX) can alleviate pressure on the basis by dampening demand for risky US dollar investments.
- Interaction effect: the cross-currency funding ratio (CCFR) amplifies the impact of the above drivers; when the CCFR is high (fourth quintile) a given shock (for example, an increase in implied FX volatility) produces a larger widening of the cross-currency basis—on the order of 50 percent larger—relative to when the CCFR is low (first quintile).

### Regulatory influences and timing effects
- Since January 1, 2015 (when European banks were first required to report quarter-end leverage ratios), quarter-end spikes in the cost of balance sheet expansion have caused jumps in the cross-currency basis, particularly affecting the one-month basis more than the three-month basis.
- Financial regulatory changes coinciding with a strengthened relationship between the CCFR and the basis include:
  - stressed VaR (2013)
  - supplementary leverage ratio (2014)
  - liquidity coverage ratio (2015)
  - US money market mutual fund reform (2016)
- The 2016 US money market mutual fund reform is associated with a sharp widening of the basis, attributed to the draining of funds out of prime institutional money market funds that had been important wholesale dollar lenders.
- Introduction of liquidity coverage ratio and other postcrisis regulations constrained US banks’ ability to supply foreign exchange swaps, strengthening the association between the CCFR and the basis.

### Financial-stress implications of tightening US dollar funding
- A tightening of US dollar funding conditions (widening of the cross-currency basis) is associated with greater financial stress in home economies of non-US banks engaged in dollar intermediation.
- Quantified impacts (regression analysis, starting from stable dollar funding conditions):
  - A 50 basis point increase in the cross-currency basis (described as the average quarterly change at the onset of the global financial crisis) is associated with:
    - a 0.22 standard deviation increase in the probability of banking sector default (equivalent to a 7½ percent increase).
    - an additional tightening of domestic financial conditions by 0.29 standard deviation.
  - The relationship is nonlinear and stronger for large increases in the basis, with prominence during the global financial crisis and the 2011 US money market fund run on European banks.
- Spillovers to recipient economies (those receiving cross-border credit from global non-US banks):
  - A 50 basis point increase in the funding costs of a recipient economy’s main lenders results in a 0.1 standard deviation increase in the probability of default of the recipient’s banking sector (equivalent to a 3.3 percent increase).
  - This spillover is quantitatively stronger and statistically significant for the top 10 US dollar cross-border recipients.

### Cross-border lending channel and substitution limits
- Cross-border lending is the main channel transmitting increased US dollar funding costs from lenders to recipient economies.
- Quantified lending responses to an increase in US dollar funding costs:
  - A 50 basis point annual cumulative increase in US dollar funding costs is associated with a reduction in US dollar cross-border lending by 5.3 percent.
  - When the lender is an emerging market: a 7.1 percent decrease in cross-border lending to all recipients and a 9.3 percent decrease in lending to other emerging markets.
  - Emerging market recipients: an increase in US dollar funding costs by 50 basis points affects US dollar lending to emerging market recipients by about –6.6 percent (about twice the effect on advanced economy recipients).
- Recipient economies’ ability to offset cutbacks:
  - An average recipient can compensate for only about half of a lender’s cutback by increasing US dollar borrowing from other lenders.
  - Emerging market recipients can compensate for only about one-quarter of the loss.
  - If US dollar funding conditions tighten across a recipient economy’s foreign lending partners, domestic banks can compensate for only 20 percent of the decline in US dollar credit.
  - Borrowing in other currencies does not substitute; instead, cross-border borrowing in other currencies falls by one-third of the initial cutback.
  - Emerging market recipients show even less ability to compensate across these margins.

### Amplification by US dollar activities and funding fragility
- Home economies with greater bank exposure to US dollar activities (measured by the share of US dollar assets to total assets) experience amplified adverse impacts from increases in US dollar funding costs.
- The cross-currency funding ratio and measures of US dollar funding fragility strengthen the transmission from higher US dollar funding costs to home-economy financial stress and to reductions in cross-border lending.

*Source: CHAPTER 5 BANkS’ DOLLAR FuNDING: A SOuRCE OF FINANCIAL VuLNERABILITY (International Monetary Fund | October 2019).*

### 1. US Dollar Funding Cost and Home Economy Financial Stress2. Effect of a 50 Basis Point Increase in Home Economy US Dol

### 1. US Dollar Funding Cost and Home Economy Financial Stress — Effect of a 50 Basis Point Increase in Home Economy US Dollar Funding Cost on Recipient Economy Financial Stress

### Association and spillovers
- Tightening US dollar funding conditions for lenders can spill over into recipient economy financial stress, especially for the lenders’ main borrowers.
- The association between financial stress in the home economy and US dollar funding costs was most prominent during the global financial crisis and the European sovereign debt crisis episode.
- A contemporaneous increase in the change of the US dollar funding cost by 50 basis points is used as the shock in the analysis.

### Quantified impacts on home economy financial stress
- Impact when share of US dollar assets is high (fourth quintile): increase of 0.32 standard deviations (an 11 percent increase).
- Impact amplified by cross-currency funding gap:
  - Statistically insignificant if cross-currency funding gap ratio is low (first quintile).
  - Increases to 0.41 standard deviations (a 14 percent increase) if cross-currency funding gap ratio is high (fourth quintile).
- Context: The average quarterly increase in the probability of default of the banking sector for this sample at the peak of the global financial crisis was 34 percent. The amplification effect of the cross-currency funding ratio, at 14 percent, is therefore equivalent to about two-fifths of this increase.
- US dollar liquidity and stable funding fragility:
  - A 50 basis point increase in US dollar funding conditions raises the probability of default of the banking sector by 0.33 standard deviations (a 10 percent increase) if the US dollar liquidity ratio is low (first quintile).
  - Impact becomes statistically insignificant if the US dollar liquidity ratio is high (fourth quintile).
  - Effects are similar for the US dollar stable funding ratio; impacts on domestic financial conditions are qualitatively similar and slightly larger in magnitude.

### Effects on cross-border lending and substitution possibilities
- US dollar funding shocks lead to a cutback in US dollar cross-border lending, particularly for emerging market lenders and recipients.
- For the full sample of recipient economies there are substitution possibilities for US dollar lending, but not into other currencies.
- For emerging market recipients there are negligible substitution possibilities into other currencies.
- Amplification of lending cutbacks: economies with more fragile US dollar funding relative to their own historical levels cut back cross-border lending by a greater amount following an additional 50 basis point increase in the one-quarter-ahead US dollar funding cost.
- Example quantification: Following a 50 basis point increase in funding costs, economies whose banking system average capital ratio is at the lowest quintile cut their US dollar cross-border lending by 4.7 percent more than those whose capital is at the fourth quintile.

### Subsidiary-branch mix and foreign presence
- Dollar liquidity held at US subsidiaries of non-US banks cannot be easily transferred to the parent and does not significantly mitigate home economy financial stress induced by tightening US dollar funding conditions.
- Foreign banking presence:
  - High share of foreign subsidiaries in the home economy does not have a significant amplification effect.
  - High share of foreign branches in the home economy is estimated to exacerbate stresses: home economies with substantial foreign branch presence experience an increase in financial system stress of 0.64 standard deviations (21 percent) in response to tightening US dollar funding.

### Mitigating factors and policy-related measures
- Stronger home economy bank health mitigates transmission:
  - Low capital ratio (first quintile): 50 basis point increase leads to 0.40 standard deviations (14 percentage points) increase in probability of default.
  - High capital ratio (fourth quintile): the impact decreases to 0.25 standard deviations (an 8 percent increase).
  - Greater overall liquidity (ratio of cash to assets) and higher profitability (return on assets) show similar mitigating benefits.
- Central bank swap arrangements with the Federal Reserve:
  - Swap arrangements limit deviation from covered interest parity by offering an alternative US dollar funding source and tend to curb funding risk.
  - Historical usage: temporary US dollar liquidity swap arrangements began in December 2007; the number of central banks engaging peaked at 14 in October 2008 and stabilized to five major advanced economy central banks in May 2010 with full allotment.
  - Event study: the Federal Reserve’s unexpected announcement on November 30, 2011 that it would lower the swap line rate by 0.5 percent was associated with noticeable narrowing of daily cross-currency bases, primarily for currencies with swap arrangements; for currencies with swap lines the basis became less negative on average and the most negative values disappeared.
  - Regression evidence: in economies with Federal Reserve swap arrangements there was no statistically significant association between the change in US dollar funding conditions and a change in domestic financial stress; without swap lines the association was statistically significant.
- Central banks’ international reserve holdings can also play a mitigating role when non-US banks face US dollar liquidity tightening.
- Policy implications noted: currency-specific liquidity management is crucial; large capital buffers and/or high profitability can offset some adverse effects of US dollar funding fragility.

*Source: IMF staff calculations (chapter content).*

### 2. Mitigation Effect of Stronger Bank Health in Home Economy on

### 2. Mitigation Effect of Stronger Bank Health in Home Economy on Cross-Border Lending

### Mitigating role of home-economy bank health
- The health of the home economy banking system can mitigate financial stress from tightening US dollar funding conditions and cushion induced cutbacks in US dollar cross-border lending.
- The analysis compares associations when capital asset ratio (capital), cash assets ratio (liquidity), and ROA in quarter t – 1 to quarter t – 4 are at the bottom (low) and the top (high) quintiles of the full-sample distribution.
- Standard errors are clustered at the economy level in all regressions. ROA = return on assets.

### Quantitative findings on funding-cost shocks and financial stress
- The figures and regressions focus on the association between a 50 basis point increase in the change in US dollar funding costs and:
  - the change in the probability of default (home economy financial stress), and
  - US dollar cross-border lending.
- With US dollar liquidity at its historical median, a 50 basis point increase in US dollar funding costs results in:
  - a 0.38 standard deviation increase in an economy with high reserve holdings (at the fourth quintile), compared with a 1.22 standard deviation increase when reserve holdings are low (at the first quintile).
- Economies with stronger capital, liquidity, and ROA (top quintiles) show weaker transmission of US dollar funding cost increases into higher probability of default and reduced cross-border lending than those with weaker metrics (bottom quintiles).

### Mitigating effects of swap lines and international reserves
- US dollar swap line arrangements mitigate the impact of increases in US dollar funding costs on home economy financial stress.
- Non-US central banks’ international reserve holdings mitigate the amplification of US dollar liquidity shortfalls:
  - Non-US central banks can use international reserves (largely denominated in US dollars) to provide contingent US dollar liquidity to the domestic financial system.
  - External providers of US dollar liquidity may be more willing to provide liquidity to an economy backed by a central bank with deep international reserves.
- Quantitative effects on cross-border lending:
  - Facing similar funding cost increases, economies with a swap line arrangement do not reduce lending significantly, whereas those without a swap line arrangement with the Federal Reserve provide about 3.2 percent less cross-border US dollar lending.
  - In economies with high international reserves (top quintile in the entire sample), cutbacks in lending are about 40 percent less than in those with low (bottom quintile) reserve holdings.

### Additional empirical details and measures used
- Panel analyses include:
  - Panel 1: box-and-whisker plots of daily three-month CCBs before and after implementation of lower swap line rates for currencies with and without access to swap lines (presample: November 1, 2011, to November 30, 2011; postsample: January 1, 2012, to January 31, 2012). Currencies with swap lines include the British pound, Canadian dollar, euro, Japanese yen, and Swiss franc. Currencies without access to swap lines include the Australian dollar, Danish krone, Norwegian krone, and Swedish krona.
  - Panel 2: association between a 50 basis point increase in US dollar funding costs and the change in the home economy probability of default, comparing presence and absence of a swap line arrangement.
  - Panel 3: transmission effect of US dollar funding fragility—the LR or SFR evaluated at their median—on the change in the probability of default when home central bank international reserve holdings are low (bottom quintile) vs. high (top quintile).
  - Panel 4: association of a 50 basis point increase in US dollar funding cost shocks with cross-border US dollar lending for economies with vs. without swap line arrangements and for economies with high vs. low central bank international reserve holdings.
- The cross-currency funding ratio, liquidity ratio, and stable funding ratio (SFR) are noted as useful monitoring tools.

### Policy implications (as stated)
- Despite benefits of reducing financial-system vulnerability, some postcrisis regulatory reforms may have had unintended consequences in global US dollar funding markets. The chapter does not recommend rolling back regulatory reforms; instead it notes that healthy capital buffers and overall liquidity in home economy banking systems can mitigate destabilizing effects of increased US dollar exposure and funding fragility.
- Trade-offs should be considered between risk abatement and reduction in financial intermediation activity, as well as between public provision of liquidity buffers and ex ante incentives to take excessive risk (moral hazard).
- Regulators should monitor the US dollar funding fragility of local banks and develop or enhance as needed currency-specific liquidity risk frameworks, including stress tests, emergency funding strategies, and resolution planning.
  - The cross-currency funding ratio, liquidity ratio, and stable funding ratio measures used in this chapter could be useful monitoring tools.
  - This is particularly important for economies exposed to or borrowing from non-US global banks, given possible spillovers from tighter US dollar liquidity conditions.
- Benefits of access to US dollar liquidity during periods of stress:
  - International reserves can play a stabilizing role in the event of stress in US funding markets and should be considered in assessing reserve adequacy.
  - Access to US dollar liquidity through swap lines at times of strain can contribute to stability, including through a signaling effect.
  - There is a case for a stronger global financial safety net, including through adequate IMF resources, such as those provided through flexible credit lines.

*Source: IMF staff calculations and analysis reported in the chapter.*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2019/october/english/ch5.pdf_