Central Banks as Dollar Lenders of Last Resort: Implications for Regulation and Reserve Holdings

This paper explores how non-U.S. central banks behave when firms in their economies
engage in currency mismatch, borrowing more heavily in dollars than justified by their operating
exposures. We begin by documenting that, in a panel of 56 countries, central bank holdings of
dollar reserves are correlated with the dollar-denominated bank borrowing of their non-financial
corporate sectors, controlling for a number of known covariates of reserve accumulation. We then
build a model in which the central bank can deal with private-sector mismatch, and the associated
risk of a domestic financial crisis, in two ways: (i) by imposing ex ante financial regulations such
as bank capital requirements; or (ii) by building a stockpile of dollar reserves that allow it to serve
as an ex post dollar lender of last resort. The model highlights a novel externality: individual
central banks may over-accumulate dollar reserves, relative to what a global planner would choose.
This is because, in the presence of imperfect regulation of currency mismatch, individual central
banks do not internalize that their hoarding of reserves exacerbates a global scarcity of dollar-
denominated safe assets, which lowers dollar interest rates and encourages firms to further increase
the currency mismatch of their liabilities. Relative to the decentralized outcome, a global planner
may therefore prefer higher capital requirements and reduced holdings of dollar reserves.