And so without further ado...
A study released this week by the BIS found that after 2000 several European banking systems, particularly the UK, Swiss, Dutch and German, expanded US dollar positions, funded primarily by borrowing in their domestic currency from home country residents.
“This is consistent with European universal banks using their retail banking arms to fund the expansion of investment banking activities, which have a large dollar component and are concentrated in major financial centres,” the BIS study says.
Most notable among the expansionary banks were UBS, Credit Suisse, Deutsche Bank, Royal Bank of Scotland, ABN Amro and Bank of Scotland.
European banks built up huge claims on foreign banking systems. By mid-2007 Swiss banks' foreign claims were eight times Swiss nominal GDP.
The major European banks recycled short-term domestic savings to invest in longer-term US assets. This mismatch of maturities was fine as long as they could roll their short term funding.
But when short-term funding dried up following the collapse of Lehman Bros, they were unable to fund their US dollar positions. Although they had off balance sheet hedging, they built up very large on balance sheet net US dollar exposures.
The build up of large net dollar positions meant they were exposed to rising costs of US dollar funding as well as the lack of availability of US dollars.
The US dollar funding gap reached between $US1.1 trillion and $US1.3 trillion by mid-2007, according to the BIS study.
When there was a sudden inability to roll over their short-term funding positions the banks had to 'deliver' foreign currency, which forced them to sell or liquidate assets earlier than anticipated, in distressed market conditions.
The short-term funding problems of the European banks were exacerbated by the run on the $US5 trillion US money market funds industry. One result of that run is that money market funds may have to become banks.
The acute shortage of US dollar funding prompted the US Federal Reserve Board to provide $US250 billion in swap lines to central banks around the world. That included swap lines to the Reserve Bank of Australia.
“The crisis has shown how unstable banks' sources of funding can become,” the BIS said.
“Yet the globalisation of banks over the past decade and the increasing complexity of their balance sheets have made it harder to construct measures of funding vulnerabilities that take into account currency and maturity mismatches,” the BIS said.
BIS concluded that many major European banks built up long US dollar positions vis-a-vis non-banks and funded them by inter-bank borrowing and via FX swaps, exposing them to funding risk. The US dollar shortage continues to this day and remains a barrier to the restoration of order in the global financial system.
The BIS paper did not address the regulatory issues raised by this episode.
But it is clear that the prudential regulators in the UK, Germany, Switzerland and the Netherlands were not monitoring closely enough the balance sheets of their banks or the basic risk prevention measures put in place to cover their net long US dollar positions.
In Australia, the Australian Prudential Regulation Authority would not allow an Australian bank to expose itself to huge foreign currency risk exposures.
It closely monitors currency risk and does a good job of keeping the banks in line not withstanding what former RBA governor Ian Macfarlane said this week about the banks being lucky. (See Saved by Dumb Luck, March 2.)
Australia's banks are not recycling domestic savings into offshore markets, but they are heavily exposed to foreign exchange risk through their term funding. Australian depositary corporations (basically banks) have around $450 billion in net foreign debt liabilities, according to this week's ABS balance of payments release for the December quarter.
This is pretty much all hedged into Australian dollars and for good reason. Australian bankers are smart enough to do it anyway, but APRA's prudential guidelines, which impose heavy capital charges for foreign exchange risk exposures, mean there is no choice.