The Bank of International Settlements – also known as the central bank of central banks – recently discovered a “hidden debt” of $65 trillion in the financial system. This is a gigantic amount that is natural fodder for sensational headlines. The big question is, of course, what exactly these debts are and to what extent this discovery poses a threat to the financial system.
That’s where I got in for you.
What exactly are these debts?
To fully understand what is going on here, we first need to understand exactly what those debts are. This mainly concerns so-called currency swaps of non-US banks and shadow banks. I will come back to currency swaps later. First, it’s important to know that the $65 trillion that these non-U.S. banks and shadow banks owe this amount to U.S. banks.
In that respect, this is yet another example of the growing degree of opacity and interconnectedness within the traditional financial system. If the pension funds, insurers (shadow banks) and non-US banks are unable to meet these debt obligations, the US banks will also run into problems. Everyone gradually becomes dependent on each other.
Currency Swaps
The debts themselves mainly exist in the form of currency swaps. These are transactions where, for example, a pension fund from Japan uses its Japanese yen to buy US dollars. It then agrees with the same party to return the US dollars at a later date in the future. They agree on a specific date and price for this.
- Japanese pension fund buys US dollars for Japanese yen
- Agrees with the same party to return the dollars on a specific date for a specific price
- An important detail is that currency swaps are usually short-term arrangements. Usually, the Japanese pension fund must return the US dollars to the counterparty within 1 year.
- The Japanese pension fund now has a debt in dollars on paper, after all, they have to return those US dollars in 1 year
The big question is, of course, why a Japanese pension fund takes on this debt. They do this, for example, to buy US government bonds with those dollars. If the interest rate on government bonds is 4 percent and they pay 3 percent for the currency swap, that could be an interesting trade.
It issue is that the US government bonds that the Japanese pension fund buys have a maturity of 10 years to have. While the currency swap has a maturity of 1 year has. In principle, the currency swap is fully covered by US government bonds.
However, it becomes problematic if the Japanese pension fund has to return the US dollars when there is a global shortage of dollars. This happened in 2008 and 2020, among others. Liquidity in US dollars dried up completely, making it difficult to impossible for parties to obtain dollars. What happens then?
Central bank takes action
At those times, the US central bank must step in to provide the system with fresh dollars. They do this at these times by opening so-called swap lines with other central banks. For example, through the central bank of Japan, they bring US dollars to the pension fund that needs dollars.
If that does not work, pension funds, insurers and non-US banks could run into problems en masse. At that point, they have to sell assets in a panic to meet their obligations. They then take huge losses on their investments or… in the worst case, they go bankrupt, because it is all too late.
The tricky thing about these currency swaps is that they do not end up on the balance sheets of non-US banks and shadow banks due to accounting rules. For that reason, the central banks do not know exactly where dollars are needed when liquidity suddenly dries up. That makes it so difficult to tackle this problem and that is why the BIS speaks of ‘hidden’ debts.
In principle, this is not an acute problem for the financial system, but it is something to keep an eye on. After all, the loans themselves are also covered by the assets that parties buy with the US dollars – in the example of the Japanese pension fund, there is a US government bond behind it. In that respect, it is not all as dramatic as it seems.
The tricky thing is that central banks, which you should see as the surgeons of the financial system, cannot really see where the problem lies at times like this. This can have potentially catastrophic consequences.
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