Central Bank Co-Operation and International Liquidity in the Financial Crisis of 2008-2009

TLDR

The 2007–2009 financial crisis blurred the line between monetary and financial stability and revived practical central bank cooperation, notably through emergency bilateral swap facilities that evolved into interconnected swap networks. The study aims to explain how central bank cooperation has evolved by analyzing the reasons for establishing swap facilities, linking swap line probability to currency‑specific liquidity shortages, and identifying significant relationships for major currencies. The authors use BIS international banking statistics to model the probability of a country receiving a swap line as a function of currency‑specific liquidity shortages, and examine the role, effectiveness, risks, and limitations of swap lines in alleviating those shortages. The analysis finds a significant link between swap line probability and liquidity shortages for major currencies and concludes that the credit crisis will likely have a lasting impact on international liquidity policies.

Abstract

The financial crisis that began in August 2007 has blurred the sharp distinction between monetary and financial stability. It has also led to a revival of practical central bank co-operation. This paper explains how things have changed. The main innovation in central bank cooperation during this crisis was the emergency provision of international liquidity through bilateral central bank swap facilities, which have evolved to form interconnected swap networks. We discuss the reasons for establishing swap facilities, relate the probability of a country receiving a swap line in a currency to a measure of currency-specific liquidity shortages based on the BIS international banking statistics, and find a significant relationship in the case of the US dollar, the euro, the yen and the Swiss franc. We also discuss the role and effectiveness of swap lines in relieving currency-specific liquidity shortages, the risks that central banks run in extending swap lines and the limitations to their utility in relieving liquidity pressures. We conclude that the credit crisis is likely to have a lasting effect on the international liquidity policies of governments and central banks.