FRM Exam Part II · The US Dollar Shortage in Global Banking and the International Policy Response

The 2007-2009 Crisis Dollar Shortage Dynamics Explained

Updated 11 October 2026 · Fact-checked

The 2007-2009 dollar shortage was a scarcity of USD funding for global banks. Interbank trust fell, money market funds pulled back, and FX swap markets seized. Basis spreads widened and banks with large USD assets but weak USD deposits faced solvency stress. Solve questions by tracing the funding source, the stress channel and the policy fix.

Understand The 2007-2009 Crisis Dollar Shortage Dynamics

Many non-US banks hold large USD assets such as US loans and securities. They lack a matching base of USD retail deposits. So they fund the gap in wholesale markets: unsecured interbank loans, commercial paper bought by US money market funds, and FX swaps that turn their home currency into dollars.

In normal times this works. In 2007 and 2008 it broke. Losses on US mortgage assets made banks doubt each other's solvency. Banks stopped lending unsecured, or lent only at very short tenors and high prices. The LIBOR-OIS spread is the gap between the unsecured interbank rate and the expected overnight policy rate. It is a gauge of credit and liquidity fear. It rose sharply, most of all after Lehman failed in September 2008.

Money market funds were a second channel. After the Reserve Primary Fund 'broke the buck' in September 2008, investors ran from prime funds. Prime funds then cut purchases of bank commercial paper and CDs, especially from foreign banks. Banks lost a major source of dollars and had to find them elsewhere.

The third channel was the FX swap market. A bank borrows USD by swapping, say, EUR for USD, and agrees to reverse the swap later. When USD became scarce, the price of borrowing USD this way rose. Covered interest parity failed: the cross-currency basis turned sharply negative, meaning borrowers paid a premium over the dollar rate implied by parity. Arbitrageurs could not close the gap because their own balance sheets and funding were constrained.

The result was a funding squeeze. Banks sold assets at fire-sale prices, cut lending, and drew on central banks. Solvency was threatened because forced sales crystallised losses and fear raised funding costs further. The policy response was Federal Reserve swap lines with foreign central banks, which lent USD to those banks against local-currency collateral.

Key formulas to remember

LIBOR-OIS spread: LIBOR-OIS spread = 3-month LIBOR − 3-month OIS rate; Read as a gauge of perceived bank credit and liquidity risk. OIS reflects expected overnight policy rates with little credit risk.
Covered interest parity (CIP): F ÷ S = (1 + i_USD) ÷ (1 + i_foreign), with S and F as USD per unit of foreign currency; Holds when arbitrage is unconstrained. Quote conventions matter. Check how the question defines S and F.
Cross-currency basis: Basis = (rate to borrow USD via FX swap) − (direct USD rate), expressed in basis points; Convention: a negative basis means a premium to borrow USD synthetically. It widened sharply in the crisis.
Funding gap: USD funding gap = USD assets − stable USD funding (such as USD deposits); The gap must be covered by wholesale markets or FX swaps, so it is exposed to rollover risk.

How to solve The 2007-2009 Crisis Dollar Shortage Dynamics questions

Use this sequence for any question on the crisis dollar shortage.

1Identify who needs dollars: usually a non-US bank with USD assets and no matching USD deposits.
2Name how it funded the gap: interbank loans, commercial paper sold to money funds, or FX swaps.
3Find the shock: US mortgage losses, loss of trust, Lehman's failure, or the Reserve Primary Fund breaking the buck.
4Trace the channel: interbank freeze, money fund run, or swap market stress. Link each to the indicator it moves.
5Read the indicator: a higher LIBOR-OIS spread means more bank credit and liquidity fear. A wider negative basis means a higher price to get dollars through swaps.
6State the consequence: asset sales, tighter lending, and solvency risk from losses and rising funding costs.
7State the policy fix: central bank USD swap lines, which supply dollars to foreign banks via their own central banks.
8Check the answer against the options for confusion between credit risk and funding liquidity risk.

Quickest way: Shock, channel, indicator, fix

When to use it: Use for multiple-choice questions that describe a stress event and ask which market, spread or policy is involved.

Underline the shock word: Lehman, money fund, swap, basis.
Match it to the channel: unsecured interbank, commercial paper, or FX swap.
Match the channel to the gauge: LIBOR-OIS for interbank, basis for swaps.
Pick the option that says dollar demand rose and supply fell.
Reject options that say arbitrage closed the gap or that the basis narrowed.

Common mistakes in The 2007-2009 Crisis Dollar Shortage Dynamics

Treating the shortage as a US bank problem only.
The word 'dollar' suggests US institutions.
Fix: Remember that non-US banks with big USD assets and thin USD deposits were most exposed.
Saying a wider LIBOR-OIS spread means expected policy rates rose.
Students confuse the spread with the level of rates.
Fix: The spread isolates the bank credit and liquidity premium, because OIS already reflects expected policy rates.
Assuming arbitrage keeps covered interest parity intact.
CIP is taught as a no-arbitrage condition.
Fix: State that balance sheet limits stopped arbitrageurs, so the basis stayed wide.
Blaming money market funds for starting the crisis.
The run on prime funds was dramatic.
Fix: Say it amplified the stress by cutting bank funding after the Reserve Primary Fund broke the buck.
Describing swap lines as the Fed lending directly to foreign commercial banks.
The end result looks like banks receiving dollars.
Fix: The Fed lent USD to foreign central banks, which lent on to their banks and took the credit risk.
Mixing up funding liquidity risk and solvency risk.
Both appear in the same stress episode.
Fix: Funding stress can cause forced sales that create losses and then threaten solvency. Name the link explicitly.

Worked examples

Example 1

A European bank holds USD 50 billion of US assets and has USD 20 billion of stable USD deposits. It funds the rest by rolling 1-month USD borrowing and FX swaps. Calculate its USD funding gap and say what happens if interbank lenders refuse to roll.

Show the solution

Funding gap = USD assets − stable USD funding.
Gap = 50 − 20 = USD 30 billion.
This USD 30 billion must be rolled repeatedly, so it faces rollover risk.
If lenders refuse, the bank must find dollars elsewhere, such as FX swaps at a higher cost, asset sales, or central bank dollars.

Answer: The gap is USD 30 billion. If rollover fails, the bank faces a dollar shortage and must pay more, sell assets or use central bank USD facilities.

Example 2

In stress, 3-month LIBOR is 4.60% and 3-month OIS is 1.60%. Before the stress the spread was 0.10%. What is the spread now, by how many basis points did it widen, and what does it suggest?

Show the solution

Spread = 4.60% − 1.60% = 3.00%.
Widening = 3.00% − 0.10% = 2.90%.
2.90% = 290 basis points.
A wider spread means higher perceived bank credit and liquidity risk in unsecured interbank lending.

Answer: The spread is 3.00% (300 bp), a widening of 290 bp. It signals severe stress in interbank funding.

Exam tips

Know the order of events: mortgage losses, loss of trust, Lehman's failure, the prime money fund run, then swap lines.
When asked for an indicator, pair interbank stress with LIBOR-OIS and swap stress with the cross-currency basis.
Watch the sign convention for the basis. Read how the question defines it before deciding if wider means more negative.
For policy questions, choose central bank swap lines as the targeted answer to the foreign bank dollar shortage.
Expect case-style items. Always say who needed dollars, why they could not get them, and what it did to the price.

Practice questions from The US Dollar Shortage in Global Banking and the International Policy Response

The 2007-2009 Crisis Dollar Shortage Dynamics: frequently asked questions

Why did non-US banks face a dollar shortage?

They held large USD assets but lacked matching USD deposits. They relied on wholesale funding, which dried up when trust fell. That left a gap they could not easily refinance.

What does the LIBOR-OIS spread measure?

It measures the gap between the unsecured interbank rate and the overnight indexed swap rate. It reflects bank credit and liquidity risk. A wider spread signals more stress.

How did money market fund runs affect dollar funding?

After the Reserve Primary Fund broke the buck, investors pulled money from prime funds. Those funds cut purchases of bank commercial paper and CDs. Banks, especially foreign ones, lost a key source of dollars.

How did the Federal Reserve respond?

It set up USD swap lines with foreign central banks. These central banks lent dollars to their own banks. This eased the shortage and pulled down funding pressure.