Dampening crises: cross-border lending and risk-weights

I’ve been reviewing tons of academic papers recently, hence why you see me posting a lot of research reviews. I’ll have a specific post on macro-prudential policy next week hopefully, but today I wish to briefly mention an interesting October 2015 paper from Philippe Bacchetta and Ouarda Merrouche: Countercyclical Foreign Currency Borrowing: Eurozone Firms in 2007-2009.

The piece is interesting because it refers to two topics I have covered at length on this blog: the importance of international financial integration and cross-border lending (implying the importance of not restricting cross-border intragroup capital and liquidity flows), as well as the negative impact of Basel’s risk weights on lending to corporations.

They looked at how a tightening domestic credit supply during a crisis impacted firms that wished to borrow. They found that reduced credit appetite from European banks led riskier corporates to switch to US banks as funding source, which in turn dampened the effects of the crisis on those firms:

We decompose our empirical analysis into three steps. In a first step we verify that foreign credit is countercyclical: when Eurozone banks tighten lending standards, riskier borrowers are more likely to obtain a loan from a foreign bank rather than from a domestic bank. We find that this effect at the intensive margin is attributable to US banks. The willingness of US banks to replace Eurozone banks can be explained by the fact that during this period and until 2012 US lenders operated fully under Basel I. Under the Basel I framework, the risk weight on risky and safe corporate debt is the same. This means that US banks have greater incentive than Eurozone banks to load onto risky corporate debt.

Did you read that? They believe that US banks were more at ease with lending to riskier borrowers because Basel 1’s risk-weights (and therefore capital requirement) were the same for both risky and safe corporates. Regulatory arbitrage at its best. This again demonstrates how Basel’s risk weights distorted the allocation of credit in the economy, as explained literally millions of times on this blog.

They then concluded that transitioning to Basel 2 subsequently made the crisis worse:

The way bank capital is regulated appears to play an important role in the process. The fact that US banks operated under Basel I meant that they had an incentive to shift to riskier corporate loans when Eurozone banks retrenched. Our analysis therefore illustrates how the move from Basel I to Basel II with risk-sensitive capital requirements has contributed to amplify 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.

I wouldn’t agree so much with their statement about Basel 3 however, which relies on the fact that regulatory authorities would be able to foresee and/or correctly assess the economic situation and take the right decisions at the right times; something some of the studies about macro-prudential policies I recently read warned about (more in a following post). A clear knowledge dispersion issue.

Finally, what this paper emphasises is the importance of cross-border lending in dampening the effects of a credit crunch. As I described in my series on intragroup funding, regulators have been trying to silo liquidity and capital in each separate banking groups’ legal entity. I believe this is misguided as it will limit or prevent cross-border funding flows and therefore the ability of subsidiaries to extend credit in foreign countries when necessary. And by attempting to strengthen each separate subsidiary, regulators are likely to make groups as a whole weaker.

PS: I spent a couple of hours earlier this week drafting a post warning against over-interpreting temporary market movements, following a few posts on the topic written by Scott Sumner (see here, here and here). I eventually decided against, as I have written about the topic before and I just couldn’t bother (perhaps I’ll change my mind later). Let’s just say that seeing market movements in the seconds or minutes following an announcement as an indicator of how markets perceived this announcement is a massive misinterpretation of the way financial markets and trading (and even worse now: HFT) work. No market actor has the ability to instantaneously process and analyse complex new information (that is why there are economists, analysts, and other commentators to enlighten market makers and investors). If EMH is valid, it is certainly not within a few minutes timeframe.

In the comment section of one of his posts, he even mentioned the wisdom of crowds as a benefit of democracy. As if Public Choice theory had never existed. No don’t get me started. Please.