Domestic Borrowers Research Articles

Gross Capital Flows by Banks, Corporates, and Sovereigns

Abstract We construct a new quarterly data set of international capital flows broken down by sector—banks, corporates, and sovereigns—and demonstrate the importance of distinguishing capital flows by the sector of domestic borrowers and lenders. We document four new sets of facts. First, banks account for the largest part of the external debt (stocks and flows) in advanced economies, whereas in emerging markets, banks, corporates, and sovereigns have roughly equal shares. Second, the high correlation between total capital inflows and outflows documented in the literature is driven by banking sector flows; that is, domestic banks’ borrowing from foreigners is highly correlated with domestic banks’ lending to foreigners. Third, sovereign flows behave very differently from and often act as a countervailing force to private sector (banking and corporate) flows, especially in emerging markets. Fourth, different shocks (global financial cycles versus domestic business cycles; banking versus currency versus sovereign crises) generate very distinct patterns of capital inflows and outflows by sector. The stylized facts we document deepen our understanding of the dynamics and behavior of capital flows and have important implications for open economy models.

Better the devil you know: Home and sectoral biases in bank lending

This paper empirically investigates banks’ lending and the extent to which they are influenced by specific preferences in terms of geographical location and industry. We study whether banks develop a field of expertise and focus on it, or whether they prefer to grant loans quite evenly among countries and industries. We manually built an original database of syndicated loans for banks in the four major banking systems in the eurozone, to estimate the determinants of loans’ amounts between 2005 and 2013. Our findings highlight a domestic bias and a sectoral bias with banks lending larger amounts to their domestic borrowers and to industries they are more familiar with.

How Does Lender Health Affect Covenant-Violating Borrowers?

Using the Emerging Market Debt Crises of the late 1990s, a shock that directly impacted some U.S. banks but not their domestic borrowers, we study the causal impact of lender health on covenant-violating borrowers. Using difference-in-differences, we find that banks exposed to the crises become relatively more likely to be stringent with covenant violators. Such stringency has real effects, as covenant violators become more likely to suffer a distressed delisting if their lenders are crisis-exposed. We also find effects for lender health on borrower investments, but these effects are not specific to covenant-violating borrowers.

Foreign Currency Mortgages Recast as Options on Commodity Futures

A foreign currency mortgage is debt for the purchase of residential property denominated in foreign currency. The borrower makes monthly payments in foreign currency. Devaluation of the domestic currency results in higher monthly payments. Practitioners have proposed solutions to avoid mortgage default. However, many of the practitioner solutions place excessive financial burdens on foreign lenders, while relieving domestic borrowers of responsibility. The goal of this paper is to present a solution that shares responsibility equitably between borrowers and lenders. First, we evaluate practitioner solutions by placing them in theoretical models. Then, the paper presents a solution, in which mortgages (loans) are viewed as derivatives (not loans). This is innovative, in that it takes mortgages out of banking and places them within investments. We recognize that investors have differential attitudes to risk. Accordingly, the proposed solution is presented in two contexts, i.e. from the perspective of a risk averse investor who shuns risk, or a risk taker, who is willing to take excessive risk to pursue returns. In the proposed solution, a call buyer may exercise the option, purchasing a futures contract to obtain the currency at a strike price that is less than the spot exchange rate. During the lengthy, uncertain delivery period, the exchange rate may vary more than the immediate period defined by the spot rate, in the form of jump diffusion models with stochastic volatility. The call buyer may purchase foreign currency at a strike price equal to the forward rates of a series of 1-period futures contracts with total life equal to the life of the mortgage. As strike prices continue to increase, with domestic currency depreciation, a repayment vehicle in the form of a portfolio of high-yielding securities is proposed, to produce the funds needed to meet forthcoming increases in monthly payments.

Cross-Border Bank Flows and Monetary Policy

We analyze the impact of monetary policy on bilateral cross-border bank flows using the BIS Locational Banking Statistics between 1995 and 2014. We find that monetary policy in the source countries is an important determinant of cross-border bank flows. In addition, we find evidence in favor of a cross-border bank portfolio channel. As relatively tighter monetary conditions in source countries erode the net worth and collateral values of domestic borrowers, banks reallocate their claims toward safer foreign counterparties. The cross-border reallocation of credit is more pronounced for banks in source countries with weaker financial sectors, which are likely to be more risk averse. Lastly, the reallocation is directed toward borrowers in safer countries, such as advanced economies or economies with an investment grade sovereign rating. By highlighting the effect of domestic monetary policy on foreign credit, this study enhances our understanding of the monetary policy transmission mechanism through global banks.

Balance Sheets, Exchange Rates, and International Monetary Spillovers

We use a two-country New Keynesian model with balance sheet constraints to investigate the magnitude of international spillovers of U.S. monetary policy. Home borrowers obtain funds from domestic households in domestic currency, as well as from residents of the foreign economy (the United States) in dollars. We assume agency frictions are more severe for foreign debt than for domestic deposits. As a consequence, a deterioration in domestic borrowers’ balance sheets induces a rise in the home currency’s premium and an exchange rate depreciation. We use the model to investigate how international monetary spillovers are affected by the degree of currency mismatches in balance sheets, and whether the latter make it desirable for domestic policy to target the nominal exchange rate. We find that the magnitude of spillovers is significantly enhanced by the degree of currency mismatches. Our findings also suggest that using monetary policy to stabilize the exchange rate is not necessarily more desirable with greater balance sheet mismatches and may actually exacerbate short-run exchange rate volatility.

The additional cost of hedging in foreign currency loans

Foreign currency denominated loans ( FCDLs) are an important part of corporate funding as well as an operational risk management tool. We show that domestic borrowers use FCDLs to hedge their foreign exchange risk exposure. FCDLs are found to carry an interest rate premium over domestic currency loans after controlling for borrower characteristics, loan characteristics, and macroeconomic conditions. We argue that borrowers are willing to pay this premium since the marginal benefit of FCDLs as a natural hedge outweighs the marginal cost. From a lender’s perspective, this premium reflects a compensation for additional foreign exchange risk exposure and intensified monitoring efforts. These results are robust to endogeneity-corrected estimations. JEL Classification: G21, G32

Contextualizing Russia's Ratings Agency: ACRA

Russia’s new Ratings Agency (ACRA) replaces the major international agencies (Moody’s, S&P, Fitch) for the purposes of assessing credit quality and assigning credit ratings to domestic borrowers in Russia. This discussion paper contextualizes this development as part of the broader trend in corporate leveraging in emerging markets and the risks to fiscal oversight created by corporate leveraging, while noting that both sanctions against Russia as well as depressed oil prices have catalyzed the current ACRA into being, as part of a strategy to address credit quality concerns and opacity in fiscal oversight of corporate leverage while the macroeconomic strains from extractive industry constraints loom large. This enriches the discussion of corporate leveraging in BRICS in light of the dramatic changes that this emerging market cohort is witnessing at present (2016).

Does reserve accumulation crowd out investment?

It is understood that investment serves as a shock absorber in times of crisis. The duration of the drag on investment, however, is perplexing. For the Asian economies we study, average investment/GDP is about 6 percentage points lower during 1998–2014 than its average level in the decade before the Asian crisis; the decline is greater if China is excluded. We document how in the wake of crisis home bias in finance increases markedly as public and private sectors look inward when external financing becomes prohibitively costly or undesirable from a financial stability perspective. Reserve accumulation involves an official institution (i.e., the central bank) funneling domestic saving abroad and thus competing with domestic borrowers in the market for loanable funds. We suggest a broader definition of crowding out and leakages, driven importantly by rising home bias in finance and by official capital outflows. We present evidence from Asia and advanced European economies with managed currencies to support this interpretation.

Foreign Currency Loans in Poland and Hungary – A Comparative Analysis

Abstract Foreign currency loans (FCL) have been commonly used in many developing countries in Europe since 2005-2006. In particular, they were granted to retail clients to finance purchasing of real estate. As interest rates in many Central and Eastern European countries were permanently higher than in Switzerland and the Eurozone, the domestic as well as foreign owned banks had started to sell mortgages in foreign currencies, predominately in Swiss francs and euros. Due to reduced interest such loans turned out to be substantially cheaper and easier to get than loans denominated in domestic currencies. In fact within 2-3 years they gained a substantial and in some cases dominant share in domestic credit markets of CEE. Because repayment of FCL is strictly dependent on the exchange rate of foreign currencies, the considered loans had exposed a large group of domestic borrowers to fx risk which they could not effectively hedge. Such risk became very serious in countries like Poland and Hungary with a clear floating exchange rate regime and substantial share of FCL among bank assets. As far back as 2008, and then in 2011 the fx risk related to such loans strongly materialised due to an unexpected rise of the valuation of the CHF and to a lesser extent the EUR. The goal of this paper is to present the phenomenon of using foreign currency loans in Poland and Hungary for purchasing real estate where such loans concentrate a substantial share of banking assets. The authors will present the nature, conditions and premises of taking such loans and will use a comparative analysis between Poland and Hungary. The paper will also contain an analysis of the influence of such loans on borrowers, banking sectors and systemic risk in both countries. The authors will provide statistical analysis of the exchange rate of PLN and HUF to present the potential of fx risk of FCL. Finally the paper will describe legal and financial supervision solutions applied in both countries to diminish the risks related to the loans.

Internal debt crises and sovereign defaults

Internal and sovereign debt crises occur together and happen more frequently in economies with weak bankruptcy institutions. This paper provides a novel explanation. Internal crises arise because of the inability to liquidate private debtors when many default. In an optimal contract, a successful entrepreneur repays yet an unsuccessful one defaults and liquidates his assets. The bounds on liquidation generate, however, a second equilibrium where domestic borrowers default because others are also defaulting. During these coordinated defaults tax collections fall which increases sovereign default risk. In the model joint debt crises are an optimal response to informational problems in private-sector lending.

Capital Inflows to Greece, Spain, Portugal and Ireland: A Sector‐Level View

AbstractGreece, Spain, Portugal and Ireland have accumulated large foreign net liabilities, exposing them to increased financial market pressure during the current crisis period. This analysis decomposes cumulated lending and borrowing over the past decade into sector‐level contributions and compares them with the euro area average. It shows strong borrowing by households and non‐financial corporations with government further increasing net borrowing in Greece and Portugal. Financial corporations act in this context as intermediaries between foreign savings and domestic borrowers. The sector‐level contributions to an economy's foreign net liabilities vary significantly by country, which implies a need for different adjustment paths. In a currency union, given the absence of a mechanism for transfer payments between member states, there is a heightened risk that large foreign liabilities will become unsustainable. Thus, member states must contain external imbalances, which often reflect a loss of competitiveness and internal imbalances, to prevent the reoccurrence of current vulnerabilities.

A Model of International Trade in Banking Services

This paper combines essential elements of the theory of intra-industry international trade with an imperfect-competition banking framework to develop a model of intra-industry international trade in banking services. The model yields the prediction that if, for instance, the production of lending services is labor intensive while the provision of deposit services is physical-capital-intensive, banks located in a foreign nation with a relatively larger labor endowment will export lending services while banks based in a domestic country with a relatively larger endowment of physical capital will export deposit services. These efficiency-based trade flows indicate that domestic borrowers and savers will be net recipients of credit and deposits, respectively, with foreign banks obtaining funds that permit them to act as net lenders to the domestic nation by borrowing from domestic banks in a global wholesale interbank funds market. A key implication of the model, therefore, is that attainment of profit-maximizing intra-industry flows of banking-service trade requires the smooth functioning of this interbank market.

L'attività internazionale delle banche italiane: una sintesi degli ultimi dieci anni (The International Activity of Italian Banks: A Synthesis of the Last Ten Years)

This paper examines the developments of the Italian banking system during the Nineties from two related points of view: net external position and degree of internationalisation, i.e. branches and subsidiaries abroad. These themes seem particularly interesting in the light of the widespread belief that the euro area will significantly increase banking competition and cross-border operations in coming years. We find two major forces driving banks' external net position: the growth in loans to domestic borrowers and the convergence in interest rate levels across European countries. The development of foreign branches and subsidiaries has been influenced by two counterbalancing forces; the big banking groups reduced their presence abroad while some medium-sized banks opened their first branches; the focus of foreign branches and subsidiaries has been on specific segments of banking activities, very often exploiting "localization" advantages. Despite the improvement in the Nineties, Italian banks have tended to show a relatively low degree of internationalisation compared with the main European banking system. JEL Codes: G21, F23 Keywords: Bank, Banking

The flight home effect: Evidence from the syndicated loan market during financial crises

This paper shows that the collapse of the global market for syndicated loans during financial crises can in part be explained by a flight home effect whereby lenders rebalance their loan portfolios in favor of domestic borrowers. The home bias of lenders' loan origination increases by approximately 20% if the bank's home country experiences a banking crisis. This flight home effect is distinct from flight to quality because borrowers of different quality are equally affected. The results indicate that the home bias in capital allocation tends to increase when adverse economic shocks reduce the wealth of international investors.

The Flight Home Effect: Evidence from the Syndicated Loan Market During Financial Crises

In the context of the global market for syndicated bank loans, we provide evidence that the collapse of international markets during financial crises can in part be explained by a flight home effect. We show that the home bias of lenders’ loan origination increases by approximately 20 percent if the bank’s country of origin experiences a banking crisis. This flight home effect is distinct from a flight to quality effect because borrowers of different quality (or from countries with different degree of investor protection) are similarly affected by lenders rebalancing their loan portfolios in favor of domestic borrowers. Banks with less stable funding sources and larger losses, being more vulnerable to liquidity shocks, exhibit a stronger flight home effect. Overall, the results indicate that the home bias of international capital allocation tends to increase in the presence of adverse economic shocks affecting the net wealth of international investors. We provide evidence suggesting that the degree of proximity to the domestic market affects the perceived risk and expected returns of banks experiencing negative shocks.

Foreign Bank Lending and Bond Underwriting in Japan During the Lost Decade

We examine foreign intermediation activity in Japan during the so-called lost decade of the 1990s, contrasting the behavior of lending by foreign commercial banks and underwriting activity by foreign investment banks over that period. Foreign bank lending is shown to be sensitive to domestic Japanese conditions, particularly Japanese interest rates, more so than their domestic Japanese bank counterparts. During the 1990s, foreign bank lending in Japan fell, both in overall numbers and as a share of total lending. However, there was marked growth in foreign underwriting activity in the international yen-denominated bond sector. A key factor in the disparity between these activities is their different clienteles: While foreign banks in Japan lent primarily to domestic borrowers, international yen-denominated bond issuers were primarily foreign entities with yen funding needs or opportunities for profitable swaps. Indeed, low interest rates that discouraged lending activity in Japan by foreign banks directly encouraged foreign underwriting activity tied to the so-called carry trades. Regulatory reforms, particularly the Big Bang reforms of the 1990s, also play a large role in the growth of foreign underwriting activity over our sample period.

Foreign Bank Lending and Bond Underwriting in Japan During the Lost Decade

We examine foreign intermediation activity in Japan during the so-called "lost decade" of the 1990s, contrasting the behavior of lending by foreign commercial banks and underwriting activity by foreign investment banks over that period. Foreign bank lending is shown to be sensitive to domestic Japanese conditions, particularly Japanese interest rates, more so than their domestic Japanese bank counterparts. During the 1990s, foreign bank lending in Japan fell, both in overall numbers and as a share of total lending. However, there was marked growth in foreign underwriting activity in the international yen-denominated bond sector. A key factor in the disparity between these activities is their different clienteles: While foreign banks in Japan lent primarily to domestic borrowers, international yen-denominated bond issuers were primarily foreign entities with yen funding needs or opportunities for profitable swaps. Indeed, low interest rates that discouraged lending activity in Japan by foreign banks directly encouraged foreign underwriting activity tied to the so-called "carry trades." Regulatory reforms, particularly the "Big Bang" reforms of the 1990s, also play a large role in the growth of foreign underwriting activity over our sample period.

Market Sentiment and Macroeconomic Fluctuations under Pegged Exchange Rates

The effects of an adverse change in market sentiment, defined as a temporary increase in the premium faced by domestic borrowers on world financial markets, are studied in an intertemporal optimizing framework with imperfect capital mobility. Firms' demands for working capital are financed by bank credit. The shock leads to a rise in domestic interest rates, capital outflows and a drop in official reserves, a reduction in bank deposits and loans, a contraction in output, and an increase in unemployment. These predictions are consistent with Argentina's economic downturn in the immediate aftermath of the Mexican peso crisis of December 1994.

Pegs, Risk Management, and Financial Crises

The paper builds a simple, micro-founded model of exchange rate management, speculative attacks, and exchange rate determination. The country can pick an ambitious peg in an attempt to signal a strong currency and thereby attract foreign capital or boost future re-election prospects. The peg, however, triggers speculative attacks that the country must withstand for the signal to remain credible. Maintaining the peg is costly to a country with an overvalued currency as it must sell the foreign currency at an unfavorable rate. We show that speculative activities can exhibit strategic complementarity or substitutability. We then relate the peg's ambition and the size of the ensuing speculative attack to the market's prior beliefs about the strength of the currency, the ability of foreign speculators to short sell the currency, domestic politics, and the initial debt composition. Finally, the model predicts that pegs and features of original sin emerge concurrently. Country hedging is endogenously incomplete as letting the residents hedge is a clear admission that the currency is overvalued by the market and makes any complementary attempt at exchange rate management futile. Similarly, we show that a peg may make domestic borrowers eager to issue short-term liabilities so as to provide foreign investors with an advantageous exit option. Furthermore, the government does not incentivize firms to lengthen the maturity structure even when it wants to because doing so would again be an open admission of a future depreciation.