INTERNATIONAL FINANCE

International Finance

International Finance

The Current Financial Crisis

The current financial crisis has highlighted just how little is known about the structure of banks' international balance sheets and their interconnectedness. During the crisis, many banks reportedly faced severe US dollar funding shortages, prompting central banks around the world to adopt unprecedented policy measures to supply them with funds. How could a US dollar shortage develop so quickly after dollar liquidity had been viewed as plentiful? Which banking systems were most affected? And how have funding pressures affected lending to non-bank end users of funds?

This special feature draws on the SIS international banking statistics to provide some tentative answers to these questions. It splices together two sets of statistics to reconstruct the global balance sheet positions for each of the major national banking systems,' The dynamics of the crisis can then be analysed across banks' consolidated balance sheets rather than along geographical (i.e. residency-based) lines. With information on both the currency and the type of counterparty for banks' foreign assets and liabilities, we can investigate how banks funded their foreign investments, and thus can better identify the vulnerabilities that threatened the financial system.

Global banking activity had grown remarkably between 2000 and mid2007. As banks' balance sheets expanded, so did their appetite for foreign currency assets, notably US dollar-denominated claims on non-bank entities, reflecting in part the rapid pace of financial innovation during this period. European banks, in particular, experienced the most pronounced growth in foreign claims relative to underlying measures of economic activity.

We explore the consequences of this expansion for banks' financing needs. In a first step, we break down banks' assets and liabilities by currency to examine cross-currency funding, or the extent to which banks fund in one currency and invest in another (via FX swaps). After 2000, some banking systems took on increasingly large net on-balance sheet positions in foreign currencies, particularly in US dollars. While the associated currency exposures were presumably hedged off-balance sheet, the build-up of large net US dollar positions exposed these banks to funding risk, or the risk that their funding positions could not be rolled over.

To gauge the magnitude of this risk, we next analyse banks' US dollar funding gap. Breaking down banks' US dollar assets and liabilities further, by counterparty sector, allows us to separate positions vis-a-vis non-bank end users of funds from interbank and other sources of short-term funding. A lower bound estimate of banks' funding gap, measured as the net amount of US dollars channelled to non-banks, shows that the major European banks' funding needs were substantial ($1.1-1.3 trillion by mid-2007). Securing this funding became more difficult after the onset of the crisis, when credit risk concerns led to severe disruptions in the interbank and FX swap markets and in money market funds. We conclude with a discussion of how European banks, supported by central banks, reacted to these disruptions up to end-September 2008.

The propagation of the global financial crisis runs along the contours of banks' consolidated global balance sheets, ...