Should we borrow in US Dollar?

A nice speech from Lars Nyberg of Riksbank. He discussed the banks’ funding in foreign currency and the risks and costs associated with this dollar funding.

During the financial crisis, many banks, both in Sweden and internationally, encountered problems due to their dependence on borrowing in foreign currency, primarily US dollars. Even though this is one of the clearest lessons from the financial crisis, it has still not led to any direct reform measures.  Mr Nyberg argued that this is a matter that must be dealt with in the long run, one way or another.

While the liquidity problems were certainly solved quite well, this was at the price of major support measures from the world’s central banks. The Riksbank’s ability to provide liquidity support in dollars to Swedish banks was facilitated by the US central bank’s dollar loans to us. If the Riksbank had been unable to borrow dollars, we would instead have had to rely on the dollar assets in the foreign exchange reserve. But regardless of whether the money comes from the foreign currency reserve or from loans, the Riksbank and the taxpayers incur a cost in providing this type of “liquidity insurance” for the banks.

The circumstance that these costs are carried by the Riksbank and the taxpayers may in itself seem unreasonable. But the fact is also that when the cost is not carried by the parties taking the risk, the probability is high that this will lead to risk-taking that, from a macroeconomic perspective, is excessive. Consequently, Mr Nyberg’s conclusion was that it would be reasonable for the banks to carry the costs of that part of the foreign currency reserve needed to provide liquidity support measures in the event of a crisis. Maintaining insufficient currency in the foreign currency reserve and trusting that other central banks will provide loans when Swedish banks encounter problems is not a sustainable strategy. The size of any charge remains to be discussed between the Riksbank and the banks.

Many central banks faced similar problems. The speech gives a nice framework to think about the issues.

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