Working Paper: NBER ID: w18528
Authors: Victoria Ivashina; David S. Scharfstein; Jeremy C. Stein
Abstract: A large share of dollar-denominated lending is done by non-U.S. banks, particularly European banks. We present a model in which such banks cut dollar lending more than euro lending in response to a shock to their credit quality. Because these banks rely on wholesale dollar funding, while raising more of their euro funding through insured retail deposits, the shock leads to a greater withdrawal of dollar funding. Banks can borrow in euros and swap into dollars to make up for the dollar shortfall, but this may lead to violations of covered interest parity (CIP) when there is limited capital to take the other side of the swap trade. In this case, synthetic dollar borrowing becomes expensive, which causes cuts in dollar lending. We test the model in the context of the Eurozone sovereign crisis, which escalated in the second half of 2011 and resulted in U.S. money-market funds sharply reducing the funding provided to European banks. Coincident with the contraction in dollar funding, there were significant violations of euro-dollar CIP. Moreover, dollar lending by Eurozone banks fell relative to their euro lending in both the U.S. and Europe; this was not the case for U.S. global banks. Finally, European banks that were more reliant on money funds experienced bigger declines in dollar lending.
Keywords: dollar funding; lending behavior; global banks; eurozone crisis; money market funds
JEL Codes: F36; F44; F6; G01; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Adverse shocks to a bank's perceived creditworthiness (E44) | decline in dollar lending relative to euro lending (F65) |
| Increased funding costs and reliance on US money market funds (F65) | cut in dollar-denominated lending relative to euro-denominated lending (F65) |
| Higher reliance on US money market funds (G19) | larger declines in dollar lending (F65) |
| Decline in dollar lending (F65) | shift in the geographic distribution of lending activity (F65) |