Global Banking Glutand Loan Risk Premium∗Hyun Song ShinPrinceton [email protected] 2012AbstractEuropean global banks intermediating US dollar funds are important in influencingcredit conditions in the United States. US dollar-denominated assets of banks outside theUS are comparable in size to the total assets of the US commercial bank sector, but thelarge gross cross-border positions are masked b y the netting out of the gross assets andliabilities. As a consequence, current account im balances do not reflect the influence ofgross capital flows on US financial conditions. This paper pieces together evidence fromaglobalflo w of funds analysis, and develops a theoretical model linking global banks andUS loan risk premiums. The culprit for the easy credit conditions in the United States upto 2007 may have been the “Global Banking Glut” rather than the “Global Savings Glut”.∗Mundell-Fleming Lecture, presented at the 2011 IMF Annual Research Conference, November 10-11, 2011.I am grateful to Olivier Blanchard for hosting the lecture. I also thank Viral Acharya, James Aitken, CarolBertaut, Claudio Borio, Michael Chui, Stijn Claessens, Laurie Pounder DeMarco, Pierre-Olivier Gourinchas,Dong He, Haizhou Huang, Ayhan Kose, Ashoka Mody, Goetz von Peter, Philipp Schnabl, Andrew Sheng,Manmohan Singh and Hui Tong for comments on an earlier draft. I thank Daniel Lewis and Linda Zhao forresearch assistance.11IntroductionReal estate booms riding on the back of rapidly increasing banking sector credit have rightlydrawn attention to the role p layed by permissive external financial conditions in the amplificationof the credit boom. Fluctuations in capital flows in recent years have ignited a liv ely debateon the nature of “global liquidity” and its transmission across borders, both for emerging andadvanced economies.Theroleofexternalfinancing conditions has been particularly relevant for the United States,with some attributing the permissive financial conditions in the United States during the middleyears of the last decade to the accumulated global current account imbalances and the “GlobalSavings Glut” emanating from emerging economies (Bernanke (2005)).Although the term “global liquidity” is often used in debates on external financial conditions,the precise definition has been more difficult to pin down. One task in this lecture will be toformulate a theoretical model of global liquidity and set it against the evidence from the globalflow of funds. It is fitting that w e revisit the issue of global liquidity in this Mundell FlemingLecture. The conceptual leap in Fleming (1962) and Mundell (1963) was to elevate internationalcapital flows as a separate component of study, not merely as the residual to the outcome fromtherealsideoftheeconomy.There ha ve been far-reaching structural changes in the operation of the global financialsystem since the late 1950s and early 1960s when the Mundell-Fleming model was formulatedand refined, and none more so than in cross-border banking. Given the importance of bankingsector portfolio decisions and the ensuing capital flows for the global financial system, it seemsa timely occasion to revisit some of the time-honored building blocks of the Mundell-Flemingmodel in the lecture that bears their names.In this lecture, I will put forward the hypothesis that cross-border banking and the fluctuatingleverage of the global banks are the c hannels through whic h permissive financial conditions aretransmitted globally. In form ulating and exploring this hypothesis, the focus will be on the2impact of global liquidity on the advanced economies, especially the United States and Europe.1My hypothesis is motivated by the evidence from an aggregate flow of funds analysis, buildingon the BIS banking statistics. The evidence points to the combination of two features that iscritically important for understanding recent events - the two elements being European banksand US dollar funding.First, we will see that the US-dollar denominated assets of banks outside the United Statesare comparable in size to the total assets of the US commercial banking sector, peaking at ov er$10 trillion prior to the crisis. The BIS banking statistics reveal that a substantial portion ofexternal US dollar claims are the claims of European banks against US coun terpart ies.Second, on the funding side, we extend earlier studies that have shown how European globalbanks financed their activities by tapping the wholesale funding market in the United States2.For instance, the interoffice accounts of foreign bank branches in the United States reveal thatforeign banks were raising large amounts of US dollar funding in the United States and thenchanneling the funds to head office. Through these and other means, the large gross claims ofEuropean banks on US counterparties are matched by their large gross liabilities to US-basedsavers.The broad picture that emerges of the role of European global banks in determining USfinancial conditions can be depicted in terms of the schematic in Figure 1. European banksdraw wholesale funding from the United States and then lend it back to US residents. Al-though European banks’ presence in the domestic US commercial banking sector is small, theirimpact on overall credit conditions looms much larger through the shadow banking system inthe United States that relies on capital market-based financial intermediaries who intermedia tefunds through securitization of claims.The role of European global banks in determining US financial conditions reinforces the1The impact of global liquidity on emerging and developing economies has been explored in Bruno and Shin(2011).2See, for instance, the BIS studies by Baba, McCauley and Ramaswamy (2009) and McGuire and von Peter(2009) on the use of US dollar wholesale funding by European global banks. Acharya and Schnabl (2009) reportthat European banks were sponsors for around 70% of the asset-backed commercial paper (ABCP) originatedprior to the subprime crisis.3US HouseholdsUSBorrowersUS Banking SectorEuropeanGlobal BanksborderWholesalefunding marketShadow bankingsystemFigure 1. European global banks add intermediation capacity for connecting US savers and borrowersimportance of tracking gross capital flows, as emphasized by Obstfeld (2012a, 2012b) and Borioand Disyatat (2011). In Figure 1, the large gross assets and gross liabilities of the Europeanbanks net out, and are not reflected in the