Ten years after the financial crisis, the specter of a global US dollar shortage is once again showing up in wholesale funding markets. Movies such as The Big Short depicted the previous crisis as the result of homeowners and Wall Street gone wild. The consensus perspective is that inadequate supervision of US mortgages coupled with greed ultimately led to an economic disaster. The prevailing logic is that the large size of the US economy and the intensity of the US downturn ultimately led to a global crisis.
The last crisis illustrated how global banks were reliant on US dollar funding
While the issue of defaulting mortgages and poor lending standards in the US was the initial catalyst of the last downturn, the issue goes much deeper. As best described in The Secret History of the Banking Crisis, the real story in 2007 was that the global Eurodollar funding system came to its knees. A Eurodollar is an offshore dollar (note the term ‘euro’ represents an offshore unit of a currency and should not be confused with euros) that can be borrowed in wholesale markets. As Eurodollars are outside the jurisdiction of the Federal Reserve, offshore US dollars enjoy minimal regulation. As such, both deposit interest rates and lending terms tend to be more attractive relative to onshore US dollar funding markets.
At the time, major banks in countries such as the UK, Germany, Switzerland, Japan, and Korea borrowed heavily from Eurodollar markets and invested the proceeds domestically and in the US mortgage market. This was a lucrative trade given the relatively low interest rates required to borrow Eurodollars and higher yields on mortgage loans and international investments. Prior the crisis, the US dollar gently weakened as the rapidly expanding supply of Eurodollars kept the currency in check. Once the financial crisis began, Eurodollar markets began freezing up and offshore banks were unable to roll-over their significant US dollar liabilities. Simultaneously, the US dollar rose sharply in value as foreign exchange markets sensed panic. Until the Federal Reserve agreed to bail out foreign banks by instituting US dollar swap lines with key central banks around the world, US dollars were in extremely short supply.
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