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

A risk officer at a European bank explains why, after 2008, the announcement of unlimited-size swap lines between major central banks reduced the cross-currency basis even when little of the facility was drawn. Which explanation is most consistent with the policy-response literature?

The announcement offered a credible dollar backstop, which reduced banks' precautionary hoarding and capped the price of obtaining dollars, so the FX swap premium and cross-currency basis narrowed even with little actual drawing. It worked through expectations and a ceiling on funding cost, not through immediate repayment.

  1. AAnnouncement created a credible backstop, lowering banks' precautionary dollar hoarding and the premium paid for dollars in FX swapsCorrect
  2. BAnnouncement forced banks to repay all outstanding dollar debt immediately, shrinking demand for dollars
  3. CAnnouncement raised the policy rate in the US, strengthening covered interest parity automatically
  4. DAnnouncement transferred bank credit risk to the Fed, eliminating counterparty risk premia in all markets

Explanation

A credible backstop caps the price of dollar funding at the swap line rate (plus a spread), reducing precautionary demand and the premium in FX swaps. The facility does not repay debt, change the US policy rate, or remove all counterparty risk; the foreign central bank remains the Fed's counterparty.

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