| Abstract: |
October 15, 2014{{p}}How Do Liquidity Conditions Affect U.S. Bank
Lending?{{p}}{{p}}Ricardo Correa, Linda Goldberg Leaving the Board, and Tara
Rice{{p}}{{p}}The recent financial crisis underscored the importance of
understanding how liquidity conditions for banks (or other financial
institutions) influence the banks' lending to domestic and foreign customers.
Our recent research Leaving the Board examines the domestic and international
lending responses to liquidity risks across different types of large U.S.
banks before, during, and after the global financial crisis. The analysis
compares large global U.S. banks--that is, those that have offices in foreign
countries and are able to move liquidity from affiliates across borders--with
large domestic U.S. banks, which have to rely on financing raised in capital
markets and from depositors to extend credit and issue loans. One key result
of our study, detailed below, is that the internal liquidity management by
global banks has, on average, mitigated the effects of aggregate liquidity
shocks on domestic lending by these banks.{{p}}{{p}}Possible Bank Responses to
Liquidity Risks{{p}}Large U.S.-based banks can react to aggregate liquidity
shocks by adjusting their domestic lending, their cross-border lending (for
example, interbank loans or claims on other counterparties), or their internal
lending and borrowing (with affiliates), or potentially make other balance
sheet adjustments. The reaction to aggregate liquidity conditions could
depend, importantly, on the composition and strength of each bank's balance
sheet. For example, if a bank has stable deposit funding or maintains more
liquid assets on its balance sheet, its lending might be less affected by
aggregate liquidity shocks.{{p}}{{p}}There also might be different responses
to liquidity risk by U.S. banks that are domestically oriented compared with
banks that are more global Leaving the Board. Because these two types of banks
have very different business models, the channels and magnitude of
transmission of liquidity risks into bank lending may differ significantly.
Small domestic banks have relatively strong lending responses to liquidity
risks (Kashyap and Stein [2000] Leaving the Board); Cornett, McNutt, Strahan,
and Tehranian [2011]). By contrast, banks with foreign affiliates,
particularly large banks, actively move funds across their organizations to
offset such risks, and potentially insulate lending in their home markets
(Cetorelli and Goldberg 2012). However, these same banks may decrease lending
abroad as they move liquidity into their home country. For both types of
banks, changes in aggregate private liquidity are likely to influence lending
differently in crisis than in normal periods, in part because of the
availability of and willingness to use official sector liquidity facilities in
periods of aggregate liquidity stress. When banks have access to central bank
liquidity facilities priced at terms below private market rates, this might
relax the constraints imposed by the composition of banks' balance sheets on
their access to external funding, leading to a different relationship between
those balance sheet characteristics and the banks' lending (Buch and Goldberg
2014 Leaving the Board).{{p}}{{p}}The Framework for Studying How Liquidity
Risks Affect Bank Lending{{p}}Two methodological building blocks underlie the
empirical strategy followed in our study. The first is Cornett, McNutt,
Strahan, and Tehranian (2011), who examine the role of bank balance sheet
composition in explaining how U.S. banks' lending reacts to changes in
aggregate liquidity conditions. They posit that banks are more sensitive to
aggregate liquidity conditions depending on the market liquidity of their
assets, the use of stable core deposits, their capital ratios, and their
funding liquidity exposure stemming from loan commitments (or new loan
originations via drawdowns).{{p}}{{p}}The second building block is Buch and
Goldberg (2014), who integrate into this framework considerations specific to
global banks, and also show the potential consequences of bank access to
official sector liquidity facilities. For the global banks, strategies for
liquidity management can play an important role and these strategies are
reflected by the use of internal funding transactions between the head office
and its domestic and foreign affiliates. The balance sheet characteristic that
reflects this feature of global banks is their reported use of "net due to" or
"net due from" their affiliated institutions, which refers to their borrowing
from or lending to other parts of the bank holding company.{{p}}{{p}}We focus
on a sample of U.S. banks, using data from 2006 through 2012. We concentrate
only on larger U.S. banks (with more than $10 billion in assets) and we
distinguish between banks with claims booked through foreign affiliates
(global banks) and those without such claims (domestic banks). These two
groups of banks can lend to both domestic and foreign borrowers. In the case
of global banks, lending to foreign residents can be arranged either through
cross-border transactions or through their foreign affiliates (which take the
form of a subsidiary or branch).{{p}}{{p}}Our measures of aggregate liquidity
strains in financial markets are the rates that banks use when lending to one
another, known as interbank spreads (such as the London interbank offered rate
over the overnight indexed swap, known as the Libor-OIS spread). As shown in
the chart below, these rates spiked during the financial crisis as U.S. and
European banks became less willing to lend to one another and liquidity dried
up, especially at maturities beyond a few days.{{p}}Figure 1: Libor-OIS
Spread, U.S. Dollar{{p}}Figure 1: Libor-OIS Spread, U.S. Dollar. This figure
shows the U.S. dollar Libor-OIS spread, calculated as the average, within a
month, difference between the three-month U.S. dollar London interbank offer
rate (Libor) and the Overnight Indexed Swap (OIS) rate for Federal Funds. The
horizontal axis ranges from January 2006 until September 2013. The vertical
axis shows the difference in percentage points between the Libor and OIS
rates. This axis ranges from 0.06 percentage points to 2.94 percentage points.
The series starts at 0.07 percentage points in January 2006 and ends at 0.16
percentage points in September 2013.{{p}}{{p}} Source: Bloomberg,
L.P.{{p}}{{p}}Our tests take into account banks' use of official sources of
liquidity. In 2008, the Federal Reserve announced a number of extraordinary
official liquidity facilities to relieve the strains in U.S. financial markets
during the crisis. Because the cost of funds at official facilities was at
times lower than private market rates, we allow for a different response of
individual banks to aggregate prices of liquidity during periods when the bank
taps official sector facilities. Thus, our analysis incorporates information
by bank on when institutions accessed the Term Auction Facility (TAF) and
discount window, and incorporates the balance sheet characteristics of these
same financial institutions as well as their global nature to understand
differences in the transmission of liquidity risk to loan and credit
growth.{{p}}{{p}}What Matters for the Effects of Liquidity Risk{{p}}We find
that elevated levels of liquidity risk, as measured by interbank spreads, have
significant, but different, effects on lending growth across different types
of large U.S. banks. The balance sheet characteristics that matter for these
different responses depend on whether the banks are global. For large,
non-global banks, the key balance sheet characteristic that explains the
impact of a funding shock on loan growth is the share of core deposits in bank
funding. The economic impact of having more core deposit funding during a
crisis is large: a bank with core deposits representing roughly 76 percent of
its total liabilities (in the 75th percentile of the in-sample distribution
for this ratio) would lend $211 million more in domestic commercial and
industrial (C&I) loans in a given quarter (about 9 percent of domestic C&I
loans of the median bank) than a bank with a core deposit share of liabilities
of 58 percent (in the 25th percentile of the distribution), after a
100-basis-point increase in the Libor-OIS spread.{{p}}{{p}}By contrast, we
find that for global banks, the impact of liquidity shocks depends more on
their liquidity management strategies, as reflected in outstanding internal
borrowing or lending between the head office and the rest of the organization.
Net internal borrowing (liabilities from the head office to its affiliates
minus claims by the head office on those affiliates) increases in periods with
heightened liquidity risk for the U.S. banks that have higher outstanding
unused commitments and lower Tier 1 capital ratios. This higher net internal
borrowing is associated with relatively more growth in domestic lending,
foreign lending, credit, and cross-border lending. The economic magnitude of
the effect of net internal borrowing on domestic C&I loans is also large: a
bank that finances 6.6 percent of the head office liabilities (in the 75th
percentile) with internal net borrowings would lend $800 million (or 5 percent
of domestic C&I lending of the median bank) more in a given quarter than a
bank that only finances 1.2 percent of its liabilities (in the 25th
percentile) with these funds, after a 100-basis-point increase in the
Libor-OIS spread.{{p}}{{p}}We find that cross-border lending and internal
borrowing and lending tend to be more volatile than domestic lending and
lending conducted through U.S. bank affiliate offices abroad. The model we
estimate explains some of the observed changes in domestic loan growth, as
well as changes in internal capital market positions, but doesn't capture as
much of the volatility in cross-border lending growth of U.S. banks. At the
same time, cross-border lending appears to be sensitive to more bank balance
sheet characteristics than any of the other forms of lending. Regardless of
the form of lending, the role of bank balance sheets is diminished when
liquidity risks increase substantially and the banks access official sector
liquidity. Thus, official sector liquidity moderates the effects of private
sector liquidity risk on both domestic lending and cross-border
flows.{{p}}{{p}}{{p}}{{p}}Ricardo Correa is a section chief in the Board of
Governors of the Federal Reserve System's International Finance
Division.{{p}}{{p}}Linda Goldberg Leaving the Board is a vice president in the
Federal Reserve Bank of New York's Research and Statistics
Group.{{p}}{{p}}Tara Rice is a section chief in the Board of Governors'
International Finance Division.{{p}}{{p}} Disclaimer: IFDP Notes are articles
in which Board economists offer their own views and present analysis on a
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