Shockwaves from Financial Crises: Follow the Geography

By: Liu, Yian
Published on: 06/10/2013
Posted on: 06/27/2013
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Investment banking is a revenue generator for large, global banks. Their impact on the financial systems of the world worries regulators however. Assets and exposures—the equities, real estate, debt securities and derivatives—originating from these divisions still have the potential to transmit international shocks. This new research shows that the reduced bank lending from global financial crisis shocks impacts investment and countries' gross domestic product (GDP). Finance professor Yian Liu of SMU Cox takes on a comprehensive analysis of 34 financial crises across nearly two decades in 100 countries.

Liu describes how financial crisis spreads across the globe through banks and their subsidiaries. "This paper says, [prop trading and other investment banking operations] did not directly lead to the crisis, but it can still transmit shocks, " offers Liu. "Regulators need to be wary of this, though they tried to address this issue with new capital requirements of Basel III." Credit contractions follow the geography of banking at the bank level (micro) and the macroeconomy level, according to the research.

This paper provides the first empirical evidence that foreign investment banking holdings can transmit capital shocks to the parent company and leave domestic lending at the mercy of international markets.  Different exposures, for example trading securities at an investment bank versus lending activities, create different dynamics or shockwaves across branches within the same holding company. The capital ratio, which says banks must have a certain amount of cash on hand or assets available, is determined at the holding company level, so all affiliates of the bank impact the ratio. Liu says, "My paper does show that banks are tilting their portfolios toward security holdings. It is hard to say how big this effect is because it depends on the nature of the shock. However as we have observed post-crisis, there is a tendency for banks to shed risk, investing in securities over lending."

The ability to choose investment banking versus commercial lending activities has increased complexity and led to new channels for international shocks to spread. These synchronized lending contractions lead to negative real effects in the real Main Street economy versus the Wall Street economy. Liu notes that in general after a recession, a 2% decline in lending occurs. "This speaks to how the risk weighting of the capital ratio can potentially be disruptive," notes Liu "Remember that lending generally grows the real economy. People think deposits are good, but banks need direct incentives to lend this money. This says a lot about the capital ratio's construction. When the capital ratio is raised, it can be a disincentive to lend, which often occurs in post-crisis periods when bank lending matters the most." But there is more to the story. 

When asked whether these shock-spillover effects have been addressed in the U.S., Liu says that there are tradeoffs. " While the crisis in Europe hurt those U.S. banks with European exposure, they have other branches they can draw liquidity from. We saw this in the recent U.S. crisis. If I have crisis in a domestic country, let's say the U.S., then other markets provide a buffer." By having international exposure, banks have more flexibility to address shocks transmitted by other countries' crises. She continues, "Being able to transfer liquidity across branches and move it to where there are lending opportunities, offers banks' gains from diversification, ie., to avoid country-level shocks. This has value and it is therefore beneficial to have multinational banks. "

The massive study

Liu studied 34 financial crises from 1990 -2007. The research contributes comprehensive evidence on international shocks originating from banks' exposure to crisis. She used data on over 4,000 bank holding company-level linkages encompassing 30 countries. Furthermore, she obtained snapshots of multinational bank holdings from 1990-2011. As an example, for 2008 Barclays had 506 cross-country company-level holdings across 65 countries. In previous research, only commercial banking (or lending) and single-country crisis impacts were studied. For example, earlier research showed that shocks to Japanese banks resulted in declines to lending at their U.S. affiliates.

This study addresses both commercial banking (lending) and investment banking (trading and investing in securities) but on both domestic and foreign fronts. Liu shows that investment banking exposure results in shocks to bank capital (its equity) whereas commercial banking exposure primarily results in shocks to liquidity (where depositors are offering fewer funds thereby reducing the bank's liabilities).

Let's look at an example of the Spanish firm Santander, with investment banking assets in Argentina and a commercial banking branch in Spain. Following an Argentinian crisis, Santander experiences a decline in the value of its assets in Argentina, which translates into a capital shock. The shock reduced Santander's returns and thus this shock to capital reduces the firm's equity on the balance sheet. The net result is a lessened reduction to their capital ratio, the golden number that says how much capital a bank must have on hand.

Now contrast this with the multinational bank, UK-based Barclays, which lends in both Spain and Argentina but has commercial banking branches in both Spain and Argentina. Barclays will face a reduction in both the value of its banking assets as well as a decline in Argentinean deposit inflows. Therefore it sees both a funding or liquidity shock as well as a capital shock. However, if Barclays' deposits decline in the crisis country, this may cause its balance sheet to shrink so that the shortfall in regulatory capital may be quite minimal, while the transmitted liquidity shock is much greater. Therefore Barclays, as a result of its commercial banking exposure, is primarily liquidity constrained whereas Santander, due to its investment banking exposure, is capital constrained.

How this difference manifests is important. "Banks with commercial banking exposure face greater liquidity constraints and therefore exhibit larger contractions in post-crisis lending," writes Liu.  "In contrast, banks with investment banking exposure are more likely to become capital constrained in which case they will cut lending as well if they have inadequate capital buffers." The impact of an investment banking shock is less than in the case of commercial bank exposure in terms of damage to the capital ratio which is a key driver for banks' lending activities. The research found that a bank with 8% more of its total holding company assets in a crisis country would see a .44 decline (from investment banking exposure) or a .78 percent decline (from commercial banking exposure) in lending in the two years following the crisis relative to a bank with less crisis exposure.

Good and bad deposits

A surprising finding emerged about areas with more stable deposit bases such as those with more fixed-income earners or retirees. In areas with greater deposit stability, the effects of investment banking exposure are amplified and result in more significant capital ratio declines. As a result, capital constrained banks exhibit greater lending contractions and increase their securities holding, Liu notes.

There are advantages to deposit stability however.  Banks with commercial banking exposure lend more in areas with greater deposit stability since a greater concentration of retirees can lessen funding constraints." (This may partially explain why regional banks have suffered less during the U.S. financial crisis of 2008-2010.)

Some banks have pushed depositors' monies away. In a post-crisis environment, it can cost banks more to accept deposits. Liu suggests however that deposits carry another benefit: "Banks should want to take deposit monies because they are a source of franchise value, " says Liu. "But in taking deposits, it costs the banks in terms of their capital ratio, taxes, and federal deposit insurance. If a bank can't lend because there were not profitable lending opportunities that increase capital, especially from the effects of recession and low returns, then additional deposits are more of a burden." She cites the Bank of NY Mellon pushing away deposits at one time. The flood of Euro crisis monies to big U.S. banks also requires the raising of more capital for these banks.

The research illuminates important policy implications. Recent policies such as the Volcker Rule have highlighted concerns that losses incurred by investment banking operations may stifle lending, according to the research. Lui's paper may be a first to show how the calculation of the capital ratio at the holding company level exposes domestic lending to foreign exposures originating from investment banking divisions.  Therefore, this transmission of capital shocks can distort lending in other countries.

In a comprehensive way, Liu describes how financial crisis spreads across the globe through banks and their subsidiaries. Her work may shed light as financial regulators across the globe attempt to rein in banks and contain their operations through 'ring fencing' regulations.

The paper "International Liquidity Sharing: Evidence from Financial Crises" by Finance Professor Yian Liu of SMU Cox School of Business is under review.

Written by Jennifer Warren.

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