The stabilising role of dollar borrowing: Eurozone firms in 2007-09

Philippe Bacchetta, Ouarda Merrouche

Economists now tend to stress the role of global banks in the transmission of the Global Crisis. This column argues that the retrenchment of Eurozone banks opened regulatory arbitrage opportunities for US banks. The fact that US banks, and in particular the most risky US banks, fully exploited these opportunities had a salubrious effect on credit-constrained corporates and employment. It seems the move from Basel I to Basel II with risk-sensitive capital requirements amplifies the credit cycle.

The recent literature on the Global Crisis has stressed the role of global banks in the transmission of the Crisis. In particular, there is evidence of financial protectionism in bank lending (Rose and Wieladek 2014) and a flight home effect in syndicated bank loans (Giannetti and Laeven 2012a). More generally, global banking flows have been shown to amplify international credit cycles (e.g. Giannetti and Laeven 2012b, Calderon and Kubota 2012) so that foreign borrowing, typically in foreign currency, declines sharply in a credit crunch.

In a context of substantial financial disintegration, it is surprising that foreign currency borrowing by many Eurozone non-financial corporates increased dramatically in 2007-2008. In a new working paper (Bacchetta and Merrouche 2015), we document this surprising aspect of international banking flows and identify the factors that led to that development. Moreover, we provide evidence that foreign banking could mitigate the transmission of the credit crunch to employment. We argue that the increase in foreign currency borrowing by Eurozone leveraged firms is a consequence of two main (and perhaps related) symptoms of the Global Crisis: the domestic credit crunch, and the drying up of global interbank markets.

Our analysis exploits loan-level data from the Eurozone syndicated loans market where foreign – that is, extra-Eurozone – banks participate as lead banks in more than 70% of the transactions. Over the period 2004 to 2009, we find that foreign credit denominated in dollar to non-financial corporates is countercyclical – it increased sharply (relative to domestic credit) in response to the sudden tightening of credit policies at domestic banks (Figure 1).

Figure 1. Syndicated loan issuance by Eurozone non-financial corporates

The cyclicality of foreign credit for risky borrowers

Interestingly, foreign dollar lending to risky borrowers increased by much more than to other borrowers (Figure 2). This is consistent with the fact that risky borrowers suffer more from the decline in domestic credit. But why did foreign banks increase lending to risky borrowers, and why was this additional lending mostly denominated in dollar?

Figure 2. Proportion of syndicated loan issuance denominated in dollar, risky versus not-risky non-financial corporates (4 per. mov. avg.)

We observe that the countercyclicality of foreign credit is mainly driven by US banks. There are two possible explanations for why US banks may rebalance their portfolios toward riskier corporates. A first explanation, for which we do not find supporting evidence, is that low Fed rates may have induced a search for yield among US banks. The other explanation is that the retreat of domestic banks meant less competition in the riskier segment of the market, and this coupled with the fact that US banks were subjected to less risk-sensitive capital requirements implies that US banks had both greater opportunities and (unlike other foreign banks) also strong regulatory incentives to shift to riskier borrowers. Since US banks were operating under Basel I the shift in risk within the same asset class had no repercussion on their capital requirement.2

We also observe that US banks that reported larger subprime losses and received assistance from their governments increased risk by more, consistent with the argument that bank bailouts encourage risk-taking by protected banks by reducing investors’ monitoring incentives and increasing moral hazard.

The mere fact that US banks played a predominant role in stabilising lending to riskier borrowers explains why credit to these borrowers shifted to dollars, owing to the fact that US banks hold limited euro deposits in a context of disrupted wholesale funding markets.

Funding markets disruptions and the rise of dollar credit

The coincident disruption in the euro interbank market caused a rise in the cost of funding in euros relative to dollars for foreign banks that had no access to ECB lending facilities. This was true for US banks in particular, but also for other foreign banks with large dollar deposits. As foreign banks passed the rise on to borrowers this caused an increase in dollar borrowing relative to euro borrowing. Across borrowers there is significant heterogeneity, with the shift to dollar being more pronounced for export-oriented firms with a natural hedged against exchange rate fluctuations.

Another explanation we give for why the exporters’ relative demand for dollars increased substantially is that exporters also faced a higher cost of swapping euros into dollars. In normal times, exporting firms find it cheaper to borrow euros and exchange them for dollars through FX swaps rather than borrow dollars directly from banks. During the period 2007-2008, however, the drying up of unsecured dollar funding markets, due to heightened counterparty risk, caused a dramatic increase in the demand for foreign exchange swap funding (a secured form of funding) by Eurozone banks who were facing increased pressure to find new sources of dollar funding. The surge in the demand for exchanging euros for dollars, combined with limited capacity on the part of arbitrageurs, caused repeated deviations from covered interest parity (i.e. the cost of swapping euros for dollars increased) causing more exporters to switch to banks for dollars.

Real effect of foreign banking

Did the rise in foreign credit matter in real terms? To answer this question, we estimated the effect of the domestic credit crunch on employment for corporates that had a pre-Crisis relationship with a foreign bank and corporates that did not. We find that risky corporates that were exposed to a weak domestic bank3 and did not have a pre-Crisis relationship with a foreign bank cut employment by 20% more than risky corporates that were exposed to a weak domestic bank but did have a pre-Crisis relationship with a foreign bank. In sum, foreign banks made a difference in real terms.

Conclusion

The retrenchment of Eurozone banks opened regulatory arbitrage opportunities for US banks. The fact that US banks, and in particular the most risky US banks, fully exploited these opportunities had a salubrious effect on credit-constrained corporates and employment. Somewhat indirectly, but convincingly, our analysis illustrates how the move from Basel I to Basel II with risk-sensitive capital requirements contributes to amplifying the credit cycle. Basel III goes some way towards addressing the problem through the introduction of mandatory buffers – a capital preservation buffer and a countercyclical buffer – that are built up in good times and can be released in bad times to avoid a credit crunch.

References

Bacchetta P and O Merrouche (2015), “Countercyclical Foreign Currency Borrowing: Eurozone Firms in 2007-2009”, CEPR discussion paper No 10927.

Calderon, C and M Kubota (2012), “Gross Inflows Gone Wild: Gross Capital inflows, Credit Booms and Crises”, The World Bank Policy Research, 6270, November.

Getter, D (2014), “US implementation of the Basel Capital Regulatory Framework”, Congressional Research Report 7-5700, 9 April.

Giannetti, M and L Laeven (2012a), “The Flight Home Effect: Evidence from the Syndicated Loan Market during Financial Crises”, Journal of Financial Economics 104 (1): 23-43.

Giannetti, M and L Laeven (2012b), “Flight Home, Flight Abroad, and International Credit Cycles”, American Economic Review 102: 219-224.

Rose, A, T Wieladek (2014), “Financial Protectionism: The First Tests”, Journal of Finance 69: 2127-2149.

Footnotes

We define risky borrowers as borrowers rated below investment grade.

2 While the US officially adopted Basel II in 2007, the date of expected compliance was delayed to 2012. See Getter (2014).

3 That is, a bank that was either closed down, recapitalised, forced into merger, or nationalised.