The Bank for International Settlements (BIS) has launched a new series of publications that it says are short, topical notes written by staff economists providing timely insights on current events in banking, markets and the wider economy. The first, issued today, looks at dollar funding costs through the prism of the FX swaps market, specifically the “basis”, which reflects the difference between dollar funding costs in the money market and that obtained via the FX swaps market.
This basis, which is usually close to zero thanks to arbitrageurs, has recently been driven into negative territory, reflecting increased dollar funding costs and while it has eased a little thanks to a group of central banks deploying swap lines, “it remains elevated for some currencies”.
The report observes that the demand side of the equation is largely made up of institutional investors, while the supply most often comes from the banking industry. The latter has been squeezed since the global financial crisis thanks to regulation, but recent events have seen banks pull back further as they have experienced drawdowns of credit lines from corporate borrowers, which have crowded out other forms of lending. Prime money market funds that traditionally supply dollar funding have also experienced redemptions, leading to thinner supply, the report notes, adding, “Together, the pullback in the supply of dollars from banks and market-based intermediaries (even as dollar demand has remained high) has resulted in the sharp increase in indicators of dollar funding costs.”
The BIS note observes that the dollar exchange rate takes on the attributes of a risk capacity indicator for the banking sector, in one way this reinforces the message from a BIS research paper earlier this year, which saw the reluctance of G-SIBs (global systemically important banks) to lend over month and quarter ends as spilling over from the FX swaps market to the spot. Reinforcing the point, the latest note says, “This reflects the tendency for an appreciating US dollar to dampen dealer banks’ intermediation capacity. For this reason, the dollar exchange rate and dollar funding costs tend to move in lock-step, as they did during the recent bout of turbulence.”
The report says that across major currencies, the basis vis-à-vis the dollar has widened recently since the start of the Covid-19 pandemic especially in short maturities. The three-month basis has widened to as much as –144 bp for the Japanese yen, –85 bp for the euro, –107 bp for the Swiss franc and –62 bp for the pound sterling, it observes, adding the same has also happened for Asian currencies, most notably the Korean won (although levels remain below those during the GFC).
Using data from the BIS OTC Derivatives Semi-Annual Survey as well as its International Statistics, the research works out banks’ demand for dollars using the gaps in their on-balance sheet dollar assets and liabilities. It finds that Canadian, Japanese and Swiss banks are net dollar borrowers in FX swap markets. Away from banks, the note argues that data show that the recent “outsized” moves in USD/JPY, for example, indicate that Japanese investor demand for dollars remains strong.
The note observes that against the backdrop of strong demand for dollars, the supply of hedging services has fluctuated with the risk capacity of financial intermediaries. “After the GFC, banking sector assets have grown noticeably more slowly, reflecting the increase in the cost of bank balance sheet capacity,” the note states. “In the meantime, banking activity became more sensitive to the strength of the US dollar.”
It adds that a “key mechanism” through which the dollar exchange rate can affect the risk taking capacity of banks is the financial channel of exchange rates. For example, a bank holding a diversified portfolio of loans to borrowers, some of whom have currency mismatches, sees its portfolio credit risk increase as the dollar appreciates. “This drives up the tail risk in dealer banks’ global portfolios, which in turn reduces their risk-taking capacity if the bank adjusts total lending so that total risk is managed down to match the bank’s economic capital,” the note explains.
It adds that that the negative relationship between the dollar index and the basis for a number of currencies means that banks’ willingness to provide FX hedging services fluctuates with the exchange rate, a relationship that has been “especially strong” during the recent market volatility.
“The shift of money market investors away from prime money market funds into government money market funds has tightened bank funding conditions further, through two channels,” the note explains. “First, banks receive less funding directly from them. Second, corporate borrowers who would normally issue commercial paper bought by money market funds have rushed to draw down their credit lines with banks, thereby crowding out other forms of bank lending. Credit line drawdowns are reported to have reached $124 billion since 1 March. Furthermore, a wider Libor-OIS spread indicates greater funding costs for banks to undertake arbitrage activities.”
It warns that in spite of the central bank FX swap lines having a dampening effect, stressed conditions remain evident in the commercial paper market and with “significant” foreign participation in the CP market, “stress in this market might spill over to the FX swap markets if firms tap these markets to obtain dollars”.
Away from the short term liquidity challenges, the note further observes that many central banks do not have swap lines with the Federal Reserve and as such will continue to face dollar shortages. This being the case, their options are limited to selling FX reserves – which could further disrupt markets – or tapping IMF finances, which “takes time”.
The note further argues that the current crisis differs from the 2008 GFC, and as such it requires policies that reach beyond the banking sector to final users. “These businesses, particularly those enmeshed in global supply chains, are in constant need of working capital, much of it in dollars,” it states. “Preserving the flow of payments along these chains is essential if we are to avoid further economic meltdown.”
Allowing non-bank firms to transact with the central bank is one option to alleviate the issue, the note suggests, but it accepts there are attendant difficulties with this approach “both in principle and in practice”.