From financial crisis to Great Recession: Evidence on the transmission role of banks

Shekhar Aiyar, 12 May 2011

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How did problems originating in one asset class in one country propagate internationally, sparking the Great Recession? A standard stylised explanation relies on the globalisation of the banking system, and has two parts.

  • First, stress in the US banking system (and others directly exposed to US mortgages and structured products) spread globally through international funding markets.
  • Second, this shock to the foreign funding of various countries’ banking systems was transmitted domestically through a reduction in credit supply. While there is a substantial empirical literature documenting the first step above (Gorton and Metrick 2009, Eichengreen et al. 2009), evidence on the second step is rather slim. This may be because of the identification problem that arises when weak bank credit is observed jointly with weak domestic demand.

The UK banking system

The UK economy provides an ideal testing ground for the transmission of the external funding shock to banks’ domestic lending. As a global financial centre, it hosts a large and heterogeneous set of banks headquartered in many different countries. Many of these banks – both among those headquartered abroad and those domestically owned – have substantial foreign liabilities, and are therefore particularly subject to contagion from abroad. And indeed, the shock to external funding that occurred during this crisis was not just large but unprecedented. Figure 1 shows a time series of the aggregate external liabilities of all UK-resident banks. These liabilities fell by 24% from their peak in end-March 2008 to end-October 2009, when they started stabilising again. By way of comparison, the previous largest six-quarter fall in external liabilities was only 9%, during the Exchange-Rate Mechanism crisis in the early 1990s.

Figure 1. An unprecedented shock to banks’ external funding

Source: Bank for International Settlements

From a balance sheet perspective, a bank can react to a shock to external liabilities in any of three ways, or some combination thereof:

(i) it can increase its domestic liabilities, that is, borrow more from resident entities,
(ii) it can reduce its foreign assets, that is, lend less to non-residents, or
(iii) it can reduce its domestic claims, that is, lend less to residents.

In recent research (Aiyar 2010), I investigate whether and to what extent banks reacted using option (iii), thereby transmitting financial contagion to the real domestic economy. I use a novel data set, created from the confidential regulatory returns that every UK-resident bank must file quarterly with the Bank of England. These reports contain detailed balance sheet data on about 140 banks, including, apart from UK-owned banks, the resident subsidiaries and branches of foreign-owned banks.

Transmission of an external funding shock

I aim to estimate the impact of the change in a bank’s external liabilities on its domestic lending during the crisis. But in principle, of course, causation between these variables can run in both directions, and moreover, domestic lending can be affected by a host of factors that are omitted from the study. To ensure accurate identification of the causation from the change in external liabilities to the change in domestic lending, the former is instrumented using three variables. These are:

(i) a measure of pre-crisis reliance on wholesale funding, viz. the share of repos in total external liabilities;
(ii) the share of external liabilities owed to affiliates (as opposed to unaffiliated entities) at the beginning of the crisis; and
(iii) a measure of banking system stress in the country in which the bank is headquartered, using the heterogeneity of Libor-OIS spreads in different regions of the world.

These instruments are intuitively appealing: all three should be indicative of the size of the funding shock – as attested by a sizable literature – while not exercising any independent impact on the response variable. Post-estimation tests offer strong support for the validity of the instruments.

Head for the exits

The main finding is that each 1% reduction in banks’ external funding caused a 0.5% to 0.6% contraction in domestic lending, a substantial impact. Given the large shock to banks’ external funding that actually occurred, it is likely that this was a crucial channel for transmitting the financial shock to the real economy.

I find evidence of a “head for the exits” phenomenon among foreign-owned banks – both branches and subsidiaries – relative to UK-owned banks. That is, the typical branch or subsidiary cut back on domestic lending to a much larger extent than the typical UK-owned bank, irrespective of the size of the shock to external funding. UK-owned banks, on the other hand, calibrated the credit pullback more closely to the size of the funding shock. This is consistent with UK-owned banks regarding domestic lending as a core business activity, and acting to preserve core business. It suggests that while all economies hosting globalised banks should have suffered contagion through the bank lending channel, the impact would have been larger in countries with a greater presence of foreign-owned banks.

There is some evidence that foreign-exchange-denominated lending was cut back more than sterling lending, but this is probably because foreign-owned banks are more likely to lend in foreign exchange. There is little evidence that foreign assets acted as a significant buffer to protect domestic lending against the external funding shock.

I also explore the transmission of the external shock to different sub-components of domestic lending. I find evidence that the shock caused a significant cutback in lending to businesses, to other banks, and to other financial institutions (with the caveat that these sub-samples of the data are smaller and noisier). But I find no evidence for a pullback from household lending. This could be because the financial crisis led to the unravelling of the securitisation model of household mortgage lending and caused banks to take mortgage securities back onto their balance sheets, a development which would tend to increase reported bank lending to households.

References

Aiyar, S (2011), “How did the crisis in international funding markets affect bank lending? Balance sheet evidence from the UK”, Bank of England Working Paper, No 424.
Gorton, G and A Metrick (2009), “Securitized banking and the run on repo”, NBER Working Paper 15223.
Eichengreen, B, A Mody, M Nedeljkovic, and L Sarno (2009), “How the subprime crisis went global: Evidence from bank credit default swap spreads”, NBER Working Paper 14904.

 

Topics: Financial markets, Global crisis, International finance
Tags: banks, global crisis, Great Recession

Senior Economist, International Monetary Fund