International Banks and the Cross-Border Transmission of Business Cycles 1

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1 International Banks and the Cross-Border Transmission of Business Cycles 1 Ricardo Correa Horacio Sapriza Andrei Zlate Federal Reserve Board Global Systemic Risk Conference November 17, These slides and associated remarks represent only the authors current opinions, not those of the Board of Governors or the Federal Reserve System.

2 Motivation Disruptions in credit markets in 2007 led the Fed and other central banks to implement non-conventional policies (for example, the Term Auction Facility). Important involvement of large U.S. and European banks global banks. Relevant role of funding via the interbank market and cross-border intrabank transactions through foreign bank branches. Foreign bank branches: 20 percent of all assets held by commercial banks in the United States in 2008.

3 Objective Objectives: Study the link between the cross-border funding activities of global banks and the international transmission of business cycles. Highlight the effects of regulatory changes on global banks ability to transform domestic deposits into loans abroad. Methodology: 1. Empirical analysis Cyclical behavior of net positions between the U.S.-based branches of foreign banks (Western Europe, emerging Asia) and their parent banks (novel dataset). The pattern of lending by U.S.-based subsidiaries of foreign banks to large and small U.S. firms. 2. Model Two-country DSGE framework with global banks (that can transform foreign deposits into local loans) and heterogeneous firms.

4 Related Literature Bank funding and liquidity management: CGFS (2010), Canales-Kriljenko, Coulibaly and Kamil (2010), McGuire and von Peter (2009), Cetorelli and Goldberg (2011) DSGE models with banks: Brunnermeier and Sannikov (2010), De Blas and Russ (2010), Gertler and Kiyotaki (2010), Iacoviello (2011), Kalemli-Ozcan, Papaioannou, and Perri (2011), Kollman, Enders, and Muller (2011), Stebunovs (2006) DSGE models with heterogeneous agents: Ghironi and Melitz (2005) Firm financing: Neumeyer and Perri (2005), Russ and Valderrama (2009)

5 Data Branches of foreign banks in the United States: FFIEC 002 report. Subsidiaries of foreign banks in the United States: FFIEC 031 report. Macro data: INTL/CEIC (real GDP growth); Federal Reserve System (effective FF rate); International Financial Statistics. "Net due to" position relative to related depository institutions (for example, relative to the parent bank) = = Gross due to related depository institutions (liability of the branch) Gross due from related depository institutions (asset of the branch)

6 Stylized Fact 1 - Balance Sheet of U.S. branches of European banks Assets Q Q Q Liabilities Q Q Q Cash 4% 11% 39% Deposits 53% 52% 52% Fed Funds Sold 1% 0% 0% Fed Funds Purchased 6% 1% 2% Resale Agreements 15% 3% 5% Repurchase Agreements 8% 3% 5% U.S. Gov. Securities 2% 2% 4% Trading Liabilities 6% 9% 5% Other Securities 21% 25% 13% Other Liabilities 18% 30% 17% Loans 24% 27% 22% Other Assets 2% 2% 2% Total Claims on Non Related Parties Net Due from Related Depository Institutions 69% 70% 85% Total Liabilities to Non Related Parties 31% 30% 15% Net Due to Related Depository Institutions 91% 95% 81% 9% 5% 19% Total Assets ($ millions) 1,193,532 1,402,416 1,328,310 Total Liabilities ($ millions) 1,193,532 1,402,416 1,328,310

7 Stylized Fact 1 - Net positions and macro factors (U.S. branches of European banks)

8 Stylized Fact 1 - Net positions and macro factors (U.S. branches of European banks) NDT ijt TA ijt = α + β 1 US GDP Growth t + β 2 Foreign GDP Growth t + + β 3 Real Interest Rate Differential t + β 4 Log Assets ijt + + θ ij + µ q + ϕ t + ɛ ijt Bank branch i, country of origin j; µ q = seasonal quarterly dummy; θ ij = bank fixed effect ϕ t = time fixed effect

9 Stylized Fact 1 - Net positions and macro factors (U.S. branches of European banks) Dependent variable: Net due to / Gross due to Gross due from Assets /Assets / Assets (1) (2) (3) U.S. GDP Growth 1.167** *** [0.536] [0.326] [0.342] Foreign GDP Growth [0.124] [0.073] [0.083] Real Interest Rate Differential * [1.019] [0.662] [0.557] Log of Claims on Nonrelated Parties *** [2.443] [1.416] [1.281] Constant ** *** *** [20.651] [12.018] [10.844] Branch Fixed Effects Yes Yes Yes Time Fixed Effects Yes Yes Yes Quarterly Dummies Yes Yes Yes Observations 4,514 4,514 4,514 Number of Branches Robust standard errors in brackets *** p<0.01, ** p<0.05, * p<0.1

10 Stylized Fact 2 - Firm size and bank lending Domestic vs. foreign banks

11 Model Assumptions Two-country (Home and Foreign), RBC model with: (1) One representative household that provides bank deposits. (2) Continuum of monopolistically-competitive firms, heterogeneous in productivity, borrow working capital from banks. (3) Two types of banks in each country: local and global. The global bank, in addition to domestic operations, also collects foreign deposits and issues loans to foreign firms. Production by heterogeneous firms: function of labor, country-specific, and firm-specific productivity. Each firm can borrow either from the local or from the global banks: Borrowing from the global banks has the advantage of a lower interest rate, but requires a per-period fixed cost. Only the larger, more productive firms access international loans; their fraction changes over time.

12 Model Assumptions

13 Representative household Maximize expected lifetime utility: [ max E t {D t, x t } subject to: s=t βs t C 1 γ s 1 γ ], (ṽ t + π t )N t x t 1 +(1+r t )D t 1 +w t L ṽ t (N t +N E,t )x t +D t + ξ 2 (D t) 2 +C t FOCs: 1 + ξd t = βe t [(1 + r t+1 ) ( Ct+1 C t ) γ ], ṽ t = β(1 δ)e t [ ( Ct+1 C t ) γ (ṽt+1 + π t+1 ) ]. Consumption basket C t is a CES aggregate of country-specific goods (described later).

14 Firms: production Following entry, each firm draws productivity factor z from a common distribution G(z) with support on [z min, ); Production: y t (z) = Z t zn t (z), with unit cost w t Z t z Firms must pay fraction φ of the wage bill before producing. Need working capital - two choices: (1) Borrow from the local bank; (2) Use an aggregate loan provided by the global banks (home and foreign).

15 Firms: prices and profits (1) Firms borrowing from local banks Profit maximization: subject to: π L,t (z) = p L,t (z)y t (z) w t n t (z) r L,t l t (z) }{{}}{{}}{{} revenue wage bill borrowing cost Equilibrium price and profit: y t (z) = p L,t (z) θ C t, l t (z) φ w t Z t z y t(z). w t p L,t (z) = θ θ 1 Z t z (1 + φr L,t); π L,t (z) = 1 θ p L,t(z) 1 θ C t.

16 Firms: prices and profits (2) Firms borrowing from global banks Profit maximization: subject to: π G,t (z) = p G,t (z)y t (z) w t n t (z) r S,t l t (z) f G w t Z t. Equilibrium price and profit: y t (z) = p G,t (z) θ C t, l t (z) φ w t Z t z y t(z). p G,t (z) = θ w t θ 1 Z t z (1 + φr S,t). π G,t (z) = 1 θ p G,t(z) 1 θ C t f G w t Z t.

17 Firms: endogenous productivity cutoff Write the firm profits as functions of productivity factor z θ 1 : π L,t (z) = 1 [ ] 1 θ θ w t (1 + φr L,t ) C t z θ 1 ; θ θ 1 Z t π G,t (z) = 1 [ ] 1 θ θ w t (1 + φr S,t ) C t z θ 1 w t f G. θ θ 1 Z t Z t }{{}}{{} slope intercept For r S,t < r L,t, define cutoff z C,t = {z π L,t (z) = π G,t (z)}.

18 Firms: aggregation Define average labor productivity for local borrowers ( z L,t ) and global borrowers ( z G,t ): Every period, N L,t firms borrow locally (z < z C,t ), and N G,t firms borrow from the global banks (z > z C,t ); So that N L,t + N G,t = N t.

19 Firms: aggregation Pareto-distributed firm productivity Firm-specific labor productivity z is Pareto-distributed: g(z) = kz min /z k+1 G(z) = 1 (z min /z) k. Under the Pareto assumption, the firm productivity averages are: z L,t = z G,t = [ z C,t 1 G (z C,t ) [ 1 1 G (z C,t ) z min z θ 1 g(z)dz ] 1 z C,t z θ 1 g(z)dz θ 1 = νz min z C,t [ z k (θ 1) C,t ] 1 θ 1 = νz C,t. z k (θ 1) min z k C,t z k min ] 1 θ 1,

20 Firms: aggregation Average prices: p L,t = p G,t = Average profits: θ θ 1 θ θ 1 w t Z t z L,t (1 + φr L,t ) w t Z t z G,t (1 + φr S,t ) (local borrowing) (global borrowing) Price index: Total profits: π L,t = 1 θ ( p L,t) 1 θ C t π G,t = 1 θ ( p G,t) 1 θ w C t f t G Z t (local borrowing) (global borrowing) N t (p h,t ) 1 θ = N L,t ( p L,t ) 1 θ + N G,t ( p G,t ) 1 θ ( ) 1 θ ( Nt (p f,t ) 1 θ = NL,t p L,t + N G,t p G,t ) 1 θ N t π t = N L,t π L,t + N G,t π G,t N t π t = N L,t π L,t + N G,t π G,t

21 Country-specific goods and trade Production Trade Prices Each firm produces variety y t (ω). All varieties ω available at period t form the country-specific good: [ Ŷ h,t = ω Ω ] θ y t (ω) θ 1 θ 1 θ dω, where θ > 1 is the elasticity of substitution across varieties. The home-specific good Ŷh,t can be consumed domestically (Y h,t ) or exported (Y h,t ), so that Ŷh,t = Y h,t + Y h,t. The home consumption basket C t is a CES aggregate of the home and foreign-specific goods, set as the numeraire (P t = 1): C t = [ (λ y ) 1 ɛy ] ɛy ɛy 1 (Yh,t ) ɛy + (1 λ y ) 1 ɛy 1 ɛy (Yf,t ) ɛy ɛy 1.

22 Banks In each economy, two types of banks (local and global) transform deposits into loans, as in de Blas and Russ (2010): L j,t = D j,t c j, where c j 1 and j {L, G}. The global bank is more productive (c G < c L ), so that r G < r L. (1) The local bank Profit: Ω L,t = r L,t (1 δ)l L,t }{{} µδl L,t }{{} r t D L,t 1 }{{} = 0. interest received monitoring cost interest paid for good loans for non-performing loans on deposits The cost c and firm exit δ introduce a wedge between r t and r L,t : r L,t = Loan clearing: L L,t = N L,t ll,t, where ( ) θ ) pl,t p h,t (Y h,t + Yh,t. ll,t = φwt Z t z L,t cl 1 δ r t + µδ 1 δ.

23 Banks (2) The global bank Interest charged for loans is a weighted average of the cost of home and foreign deposits: ( ) D H,t 1 cg r t +µδ DH,t 1 r G,t = D H,t 1 +D + Q ( t cg r ) H,t 1Q t 1 δ D H,t 1 +D t Q t +µδ H,t 1Q t 1 δ Market clearing for the global loans: L S,t = Allocation of deposits [λ 1 ɛ L ɛ 1 ɛ H,t + (1 λ) 1 ɛ 1 ] ɛ ɛ 1 ɛ L ɛ F,t = N G,t lg,t. Home deposits D t 1 are allocated in fixed shares across the home local, home global, and foreign global banks: S L + S H + S F = 1. Bank lending constraints L H,t +L H,tQ t = S H D t 1 +S H D t 1 Q t c G and L F,t+ L F,t Q t = S F D t 1 +S F D t 1 /Q t. c G

24 Closing the model Net lending (Net Due To Position) by foreign branches in Home: NDTPt = 1 [ L F,t S ] F D t 1 Q t cg. Net lending by home branches abroad: [ NDTP t = Q t L H,t S H ] D t 1. c G The balance of payments equation: p h,t Yh,t p f,t Q t Y f,t }{{} net exports + r t S F D t 1 r t S H D t 1Q t }{{} net interest payments = S F (D t D t 1 ) SH ( D t Dt 1) }{{}. change in stock of foreign assets

25 Calibration Standard quarterly calibration: β = 0.99 Discount factor γ = 2 CRRA coeffi cient θ = 3.8 Intra-temporal elasticity of substitution f E = 1 Firm s sunk entry cost k = 3.4 Pareto distribution parameter δ = Probability of firm exit φ = 0.5 Share of wage bill to be financed f G = Firms fixed cost for global loans C L = 1.05, C G = 1.01 Cost parameter, local and global bank S L = 0.4, S H = 0.3, S F = 0.3 Share of home deposits µ = 0.01 Banks monitoring cost ε λ = 1.4 Substitution, home and foreign loans λ = 0.5 Share of home global bank in syndicate Steady state: 1% of firms borrow globally, account for 9% of total borrowing; foreign banks provide 5% of total lending.

26 Impulse responses % deviations from steady state, (+) TFP shock in Home (ρ = 0.9):

27 Further work Study the model dynamics in response to shocks: A positive TFP shock in Home: firms ability to access foreign deposits amplifies the expansion; as more of the small firms gain acess to international loans further amplification. A negative TFP shock in Home: international bank lending exacerbates the contraction. Analyze the implications of proposed Basel III liquidity standards that would decrease the amount of intrabank funding: Limit banks ability to use deposits from one country to make loans in another.

28 Stylized Fact 2 - Firm size and bank lending Domestic vs. foreign banks

29 Stylized facts - Net positions and macro factors (U.S. branches of Asian banks)

30 Stylized facts - Net positions and the demand for dollar funding

31 Stylized facts - Net positions and the demand for dollar funding Dependent variable: Net due to / Assets Gross due to /Assets Gross due from / Assets Net due to / Assets Gross due to /Assets (1) (2) (3) (4) (5) (6) Gross due from / Assets Dummy Crisis * ** 4.366*** [2.574] [2.367] [1.313] [1.489] [1.474] [0.663] Dummy Europe *** *** 9.231*** [2.760] [2.423] [1.402] Dummy Crisis X Dummy Europe 7.454* * 8.478*** 4.959** 3.519** [3.902] [3.456] [1.955] [2.694] [2.438] [1.581] Constant *** *** *** *** *** *** [1.760] [1.671] [0.913] [0.616] [0.577] [0.332] Branch Fixed Effects No No No Yes Yes Yes Observations 1,204 1,204 1,204 1,204 1,204 1,204 R squared Robust standard errors in brackets *** p<0.01, ** p<0.05, * p<0.1

32 Firm Entry with Sunk Costs Firm entry Firm entry takes place untill the sunk entry cost equals the net present value of the average firm, as in Ghironi and Melitz (QJE, 2005): f E w t Z t = ṽ t, where: ṽ t = E t s=t+1 ( ) γ [β(1 δ)] s t Cs π s. C t The law of motion for the number of producing firms is: N t+1 = (1 δ)(n t + N E,t ).

33 Calibration exercise Vary the fixed cost f G of international borrowing:

International Banks and the Cross-Border Transmission of Business Cycles

International Banks and the Cross-Border Transmission of Business Cycles Ricardo Correa Horacio Sapriza Andrei Zlate PRELIMINARY AND INCOMPLETE. PLEASE DO NOT CITE. June 15, 2011 Abstract We study the