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Global Banking Glut and Loan Risk Premium



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Global Banking Glut and Loan Risk Premium Hyun Song Shin Princeton University hsshin princeton edu January 2012 Abstract European global banks intermediating US dollar funds are important in influencing credit conditions in the United States US dollar denominated assets of banks outside the US are comparable in size to the total assets of the US commercial bank sector but the large gross cross border positions are masked by the netting out of the gross assets and liabilities As a consequence current account imbalances do not reflect the influence of gross capital flows on US financial conditions This paper pieces together evidence from a global flow of funds analysis and develops a theoretical model linking global banks and US loan risk premiums The culprit for the easy credit conditions in the United States up to 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 Carol Bertaut 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 for research assistance 1 1 Introduction Real estate booms riding on the back of rapidly increasing banking sector credit have rightly drawn attention to the role played by permissive external financial conditions in the amplification of the credit boom Fluctuations in capital flows in recent years have ignited a lively debate on the nature of global liquidity and its transmission across borders both for emerging and advanced economies The role of external financing conditions has been particularly relevant for the United States with some attributing the permissive financial conditions in the United States during the middle years of the last decade to the accumulated global current account imbalances and the Global Savings 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 di cult to pin down One task in this lecture will be to formulate a theoretical model of global liquidity and set it against the evidence from the global flow of funds It is fitting that we revisit the issue of global liquidity in this Mundell Fleming Lecture The conceptual leap in Fleming 1962 and Mundell 1963 was to elevate international capital flows as a separate component of study not merely as the residual to the outcome from the real side of the economy There have been far reaching structural changes in the operation of the global financial system since the late 1950s and early 1960s when the Mundell Fleming model was formulated and refined and none more so than in cross border banking Given the importance of banking sector portfolio decisions and the ensuing capital flows for the global financial system it seems a timely occasion to revisit some of the time honored building blocks of the Mundell Fleming model in the lecture that bears their names In this lecture I will put forward the hypothesis that cross border banking and the fluctuating leverage of the global banks are the channels through which permissive financial conditions are transmitted globally In formulating and exploring this hypothesis the focus will be on the 2 impact of global liquidity on the advanced economies especially the United States and Europe 1 My hypothesis is motivated by the evidence from an aggregate flow of funds analysis building on the BIS banking statistics The evidence points to the combination of two features that is critically important for understanding recent events the two elements being European banks and US dollar funding First we will see that the US dollar denominated assets of banks outside the United States are comparable in size to the total assets of the US commercial banking sector peaking at over 10 trillion prior to the crisis The BIS banking statistics reveal that a substantial portion of external US dollar claims are the claims of European banks against US counterparties Second on the funding side we extend earlier studies that have shown how European global banks financed their activities by tapping the wholesale funding market in the United States2 For instance the intero ce accounts of foreign bank branches in the United States reveal that foreign banks were raising large amounts of US dollar funding in the United States and then channeling the funds to head o ce Through these and other means the large gross claims of European banks on US counterparties are matched by their large gross liabilities to US based savers The broad picture that emerges of the role of European global banks in determining US financial conditions can be depicted in terms of the schematic in Figure 1 European banks draw 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 their impact on overall credit conditions looms much larger through the shadow banking system in the United States that relies on capital market based financial intermediaries who intermediate funds through securitization of claims The role of European global banks in determining US financial conditions reinforces the 1 The impact of global liquidity on emerging and developing economies has been explored in Bruno and Shin 2011 2 See 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 report that European banks were sponsors for around 70 of the asset backed commercial paper ABCP originated prior to the subprime crisis 3 European Global Banks Shadow banking system US Borrowers Wholesale funding market US Banking Sector US Households border Figure 1 European global banks add intermediation capacity for connecting US savers and borrowers importance of tracking gross capital flows as emphasized by Obstfeld 2012a 2012b and Borio and Disyatat 2011 In Figure 1 the large gross assets and gross liabilities of the European banks net out and are not reflected in the current account that tracks only the net flows To the extent


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