-Eurozone Banks Cut Dollar Lending More Vs Euro Lending Due To Crisis

By Brai Odion-Esene

WASHINGTON (MNI) – European banks, who do a large share of
dollar-denominated lending, scaled back such lending due to the sovereign debt
crisis, highlighting a channel through which shocks abroad can be felt in the
U.S. economy, according to a working paper co-authored by Fed Board Gov. Jeremy
Stein published Wednesday.

Written together with Harvard economists David S. Scharfstein and Victoria
Ivashina, the paper presented a model in which Eurozone 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,” it said.

“This paper identifies a channel through which shocks outside the U.S. can
affect the ability of U.S. firms to borrow,” Stein et al wrote. “Although dollar
lending by foreign banks increases the supply of credit to U.S. firms during
normal times, it may also prove to be a more fragile source of funding that
transmits overseas shocks to the U.S. economy.”

They cautioned, however, that the ultimate cost of Eurozone bank
retrenchment on dollar borrowers is difficult to assess at this point, adding
that more analysis is needed of the borrowing behavior of firms that previously
relied on the Eurozone banks for dollar funding.

In addition, the economists said it is possible other banks — either U.S.
or non-European banks — may have stepped in to fill the hole left by the
retrenchment of the Eurozone banks.

The paper pointed to evidence that Japanese banks have increased their
presence in dollar loan markets, and that U.S. firms may also have turned to the
bond market.

“Since European banks tend to lend to large, highly-rated U.S. borrowers,
one suspects that such substitution might be smoother than it would be with a
different population of borrowers,” it said.

On the matter of European banks cutting their dollar lending by more
compared to euro lending — despite the fact that European economies were more
threatened by the debt crisis — the paper argued that this is a consequence of
two features in the markets in which European banks fund themselves.

“First, European banks rely on less stable wholesale dollar funding sources
to finance their dollar lending whereas a good deal of their euro lending is
financed with stickier euro deposits. Second, frictions in the foreign exchange
swap market limit the extent to which Eurozone banks can use euro deposits to
fund their dollar lending,” the paper said.

Stein et al said that as swap demand from Eurozone banks rises, there is
only limited arbitrage capital available to take the other side of the
trade, which increases the cost of engaging in this synthetic dollar borrowing.

“Thus Eurozone banks adjust to strains in wholesale dollar funding markets
by borrowing more in euros, but also by cutting back their dollar lending
relative to euro lending,” the paper concluded.

The working paper was published as part of the Finance and Economics
Discussion Series, which the Fed stressed are preliminary materials circulated
to stimulate discussion and critical comment, with the analysis and conclusions
solely those of the authors.

** MNI Washington Bureau: 202-371-2121 **

–email: besene@mni-news.com

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