Yves here. This article discusses how the effort to move away from the dollar in trade has knock-on effects to bank behavior, in particularly lower supply of credit and therefore slower growth. Divorce is not cost free.
By Claudia Buch, Vice President Deutsche Bundesbank; Linda Goldberg, Senior Vice President and Financial Research Advisor Federal Reserve Bank Of New York; and Björn Imbierowicz, Economist Deutsche Bundesbank. Originally published at VoxEU
Recent geopolitical events have raised concerns that markets for goods and services could become more fragmented. Clearly, trade uncertainty has increased. The consequences for financial intermediation of fragmentation and uncertainty are not well understood though. If banks affected by adverse trade events contract lending, the effects of the initial shock for the real economy could be amplified. Studies conducted in the International Banking Research Network show that fragmentation shocks reallocate and sometimes reduce overall credit supply through banks. This reallocation can reinforce fragmentation and change the consequences from trade disruptions.
Over the past decade, threats of restrictive trade policy and geopolitical risks have emerged and intensified. There has been a series of adverse shocks to globalisation (Aiyar et al. 2023): the trade conflict between China and the US, Brexit, the Covid pandemic, and Russia’s war of aggression against Ukraine. These shocks can affect bank credit provision. Banks are important for financing international trade and providing credit to the real economy. 1 Trade policy and uncertainty shocks might even be reinforced by banks, domestically and internationally, by transmitting financial stress through lending and liquidity flows (e.g. Peek and Rosengren 2000, Cetorelli and Goldberg 2012, Schnabl 2012, De Haas and Van Horen 2013, Niepmann 2015, Niepmann and Schmidt-Eisenlohr 2017, Amiti and Weinstein 2018, and Federico et al. 2020).
The International Banking Research Network (IBRN) initiated a project where country teams investigated how trade uncertainty, fragmentation events and deglobalisation shocks are amplified through the supply of credit. Studies use granular confidential regulatory data on banks to show how fragmentation shocks reallocate and sometimes reduce credit supply through banks. This reallocation both reinforces fragmentation and influences the pattern of consequences from trade disruptions. Studies draw on detailed information about the specific shocks to firms (to capture the demand side) and banks’ exposures to those firms, along with bank characteristics (to capture the supply side).
Specific episodes explored include the effects of Russia’s invasion of Ukraine in 2014 on Italian banks (Federico et al. 2023), of the Brexit referendum on German banks (Imbierowicz et al. 2023), of retaliatory trade restrictions from China onNorwegian banks (Cao et al. 2022), of the euro area sovereign debt crisis on Portuguese banks (Bonfim and Fèlix 2023, Pedrono 2022), and of the increase in uncertainty since 2016 from intensifying trade tensions between the US and China on US, Chilean, and Mexican banks (Correa et al. 2023, Margaretic and Moreno 2023, Bush et al. 2023). Other work looks at changes in services trade in a broad range of economies from 2014 through 2019 (Lloyd et al. 2022 for the UK) or at the geographic specialisation of banks from 2006 to 2019 (Pedrono 2022).
Trade Fragmentation Spills Over into Bank Lending Activity
All studies confirm that banks’ credit supply responds to trade fragmentation shocks and increased uncertainty. When a fragmentation event occurs, banks decrease their supply of credit. This effect goes beyond the firms immediately affected as banks also restrict credit to firms which are not directly exposed to the event. Hence, the initial shock is amplified across the universe of bank borrowers.
The magnitude of the decline in credit differs across countries. As regards large US banks, those exposed to trade uncertainty reduce credit originations by 0.5 percentage points, which compares to an average growth rate of 4.2% prior to the shock (Correa et al. 2023). A standard deviation increase in Italian bank exposure (around 0.45 percentage points) to a trade shock is associated with a 0.8 percentage point decrease in credit supply (Federico et al. 2023) and high-exposure Norwegian banks decrease their lending in all lending categories by 3-6% following the trade shock (Cao et al. 2022). Given the differences in the type of shock and the measures used for analysis, the results overall suggest a generally material effect on bank credit supply.
Trade shocks are transmitted through increased risks of loans on banks’ balance sheets. On impact, trade shocks have adverse effects on the financial soundness of firms. Firms experience a decline in revenues, lower liquidity, and a higher propensity of loan default (Federico et al. 2023). 2 Banks respond to higher risks and uncertainty arising from international trade shocks by taking precautionary measures. They increase loan loss provisioning and reduce risk taking. This manifests as a contraction of credit to riskier borrowers, and not just to those exposed directly to the initial uncertainty.
This type of mechanism is identified from analyses of banking responses in Chile, Germany, Italy, Norway, and the US. US banks, for example, contract credit supply more for firms that are more informationally remote, that strongly rely on trade finance, are that are internationally integrated into global value chains. Firms facing larger information asymmetries, such as having shorter banking histories and being foreign firms, are also affected more. US banks which are exposed to higher uncertainty curtail loans specifically designated for investment.
Borrowers relying on financing through banks exposed to trade uncertainty are unable to fully substitute reduced lending with alternative external sources of credit. Accordingly, a contraction of credit supply can have adverse impacts on firms in terms of lower ability to borrow, capital expenditures, and asset growth (Correa et al. 2022). In Chile, banks reallocate credit from firms in nontraded sectors to those involved in global value chains, and to a lesser extent, to importers who are exposed to countries exhibiting an increase in trade uncertainty (Margaretic and Moreno 2023). Portuguese banks more exposed to foreign firms decrease loan supply during crises but increase lending towards domestic firms (Bonfim and Félix 2023). In Germany, banks reduce credit supply to less profitable firms following the Brexit events (Imbierowicz et al. 2023). Some subsidiaries of large multinational corporations can access internal cross-border capital markets in response to the credit supply shock, mitigating some of the negative real economic outcomes. Overall, these banking channels add to the broader set of effects of Brexit on UK firms (Bloom et al. 2019).
Some Types of Banks Are More Prone to Credit Supply Adjustments
Beyond their direct balance sheet exposures to the firms impacted by trade events, the characteristics of banks matter for the magnitude of their credit supply response to international trade disturbances.
The resilience of banks matters for their response to shocks. Large US banks with lower levels of capital and a higher dependence on market funding reduce lending by more than their better capitalised peers or those relying more on retail funding. Similarly, relative to their peers, German banks with lower levels of capitalisation and lower return on assets tend to have larger reductions in their credit supply to firms which are not directly exposed to the event. The adjustment by Chilean banks which are smaller is to extend new loans with shorter maturities and higher interest rates.
The geographic presence of bank affiliates in foreign countries has an impact as well. Generally, the contraction of credit is larger for banks with business models that support global trade as measured by the extent to which banks engage in trade finance and have loan exposures to foreign residents. The UK study looks at differences across banks with and without foreign affiliates (Lloyd et al. 2022). Banks without foreign affiliates decrease cross-border lending. Those banks with a foreign affiliate decrease intragroup lending, but increase direct cross-border lending. Barriers to competition have the strongest impact especially for banks which have already established a presence in the other country. The geographic specialisation of banks also determines the relationship between bilateral cross-border lending of banks and bilateral trade of firms: more geographically specialised banks provide more cross-border lending to firms in the same industry in which they specialize, but less so following an adverse trade shock (Pedrono 2022). Similarly, under increased trade uncertainty surrounding the renegotiation of the North American Free-Trade Agreement (NAFTA), foreign banks operating in Mexico with their parent headquartered in the US and Canada reduced credit supply, while those with foreign parents elsewhere, increased credit supply (Bush et al. 2022).
Trade policy uncertainty and fragmentation events have become major concerns for global production and trade (Fajgelbaum and Khandelwal 2021), with simulations showing that these events could lead to substantial reductions in economic growth (Bolhuis et al. 2023). Cross-country studies organised by the International Banking Research Network emphasise additional financial-sector factors that can affect credit supply and output effects of fragmentation events. Adverse trade shocks affect banks’ borrowers, and the effects of those shocks are amplified through contractions in credit supply. Importantly, these effects go beyond the specific firms that are directly affected by the trade-related events. This body of research shows that shocks to banks, which derive from borrowing firms’ exposures to trade and trade uncertainty, generate ripple effects. A decline and reallocation of bank credit supply can reinforce fragmentation and potentially slow the adjustment of firms to trade shocks. A general conclusion from very detailed studies is that banks that are more resilient – with diversified portfolios, better capitalisation and liquidity buffers –are better placed to absorb adverse shocks and maintain lending, containing some of the adverse spillovers from trade shocks through credit supply.
See original post for references
The word “sanction” is not used once.
I’ll be damned. You’re right. One third of the world under US sanctions and the epic blowback of the sanctions against Russia and no direct mention of them at all. I don’t think that the weaponization of SWIFT got a mention either. How do you miss that development too?
Econ 102…assume a freely competitive market. ;-)
It is hard for me to read an article that has in its lede paragraph, “Russia’s war of aggression against Ukraine.” Such an outlook discredits the author as a foolish compliant in Western propaganda. Anyone with a brain and access to the Internet should know that there is no war of aggression except that committed by NATOized Kyiv against the people of the Donbas who rejected the government emerging from Maidan in 2014.
Whether accurate or not, the Russians, led by President Putin, believed (from their evidence) that an assault on the Donbas by Ukraine was imminent and because of Kyiv rhetoric, believed that not only would a genocide take place, but that deadly weapons would be installed right on Russia’s border, missile minutes from Moscow. Thus, the ‘aggression’ was an intervention to protect the lives of the ethnic Russian people of the Donbas and the Russian people in the Motherland.
You are exhibiting a cognitive bias called halo effect, of insisting on seeing things as all good or all bad.
The point of this sort of article is its economic analysis, not its political asides. Its authors do not hold themselves out as experts on geopolitics. They are not in a position to credibly question the prevailing view in Europe even if they wanted to.
This sort of view is pervasive in academia and elite NGOs, and expecting an article like this to go with what is very much a counternarrative, even as an aside, would assure it would not be published or the editors would insist on any such statement’s removal. Alexander Mercouris has pointed out that unlike the US, where there is some dissent from the mainstream story line getting out due to admissions Ukraine is doing badly and a few ant-war voices like Tucker Carlson, the media coverage of the war in the UK and Europe is far more lockstep Russia-hostile.
Recently there have been some market swings in spot oil and gas markets due to inability to get credit/margin. “The alarming dollar connections between oil plunge and Germany’s sudden and shocking collapse.”
The irony of this situation is that the US is more financialized than most of the world, and as a result the sanctions that caused the fragmentation to occur are going to be disproportionately harmful to the US financial interests.
It’s going to mean less credit supply all around. One positive may be less speculators, as a high percentage of the credit issued was being used for harmful effects. However, even then, some capital was being used for productive investment in the real economy and that’s going to be tighter too.