FED of San Francisco working paper 2016-01
18 March 2016
Source: Federal Reserve Bank of San Francisco
Galina Hale, Federal Reserve Bank of San Francisco
Tuemer Kapan, Fannie Mae
Camelia Minoiu, International Monetary Fund
We study the transmission of financial sector shocks across borders through international bank connections. For this purpose, we use data on long-term interbank loans among more than 6,000 banks during 1997-2012 to construct a yearly global network of interbank exposures. We estimate the effect of direct (first-degree) and indirect (second-degree) exposures to countries experiencing systemic banking crises on bank profitability and loan supply. We find that direct exposures to crisis countries squeeze banks’ profit margins, thereby reducing their returns. Indirect exposures to crisis countries enhance this effect, while indirect exposures to non-crisis countries mitigate it. Furthermore, crisis exposures have real effects in that they reduce banks’ supply of domestic and cross-border loans. Our results, based on a large global sample, support the notion that interconnected financial systems facilitate shock transmission.
In this paper we analyze the role of bank connections in the transmission of financial sector shocks across countries. Using detailed data on long-term interbank loans, we construct foreign interbank exposures, and hence a global banking network for the 1997-2012 period. These interbank exposures, which are positively correlated with total foreign exposures, capture both idiosyncratic risk and country risk. Our global banking network comprises more than 6,000 banks. Of these, we have financial statement data for a sample of 1,869 banks, which enables us to document the impact of exposures to banks in countries experiencing crises on bank profitability and loan supply.
We find that a larger number of direct loan exposures to bank borrowers in countries experiencing systemic banking crises reduces bank returns and the granting of large corporate loans, controlling for time-varying borrower demand. On top of this negative effect, indirect, second-degree exposures to borrowers in crisis countries have an additional negative impact, while exposures to borrowers in non-crisis countries have a dampening effect. A possible mechanism for reduced bank returns stems from loan restructuring, a common method of dealing with impaired syndicated loans, which squeezes banks’ net interest margins. In the face of shocks to asset values and possible information contagion stemming from troubled exposures abroad, banks also reduce the supply of loans, especially that of cross-border loans.
Our results, which suggest that banks are unable to shield their balance sheets fully from foreign risk, may be interpreted as evidence of market incompleteness. Furthermore, they illustrate how interactions in the long-term interbank market affect bank profitability and the flow of credit in the global economy, thereby supporting the notion that interconnected financial systems enable shock transmission.