International Financial Integration, Crises, and Monetary Policy: Evidence from the Euro Area Interbank Crises
Since the mid-1980s, international capital flows have increased due to improved cross-border financial integration. However, the greater interconnection has exacerbated the effect that adverse liquidity shocks may have upon the world’s financial system. In September 2008, the failure of Lehman Brothers, a U.S. investment bank, marked the peak of the global financial crisis, which central banks combated using new and unprecedented policy measures. By early 2010, another crisis erupted in the euro area—due to concerns about sovereign default in Greece, Ireland, and Portugal and the health of Spain’s banking sector (collectively, the GIPS countries)—that prompted the European Central Bank (ECB) to engage in repeated rounds of intervention over a multi-year period. Despite the importance of understanding how financial crises affect cross-border lending channels, and whether the new and expansionary nonstandard monetary policy actions have helped repair financial markets, there is a dearth of empirical analysis on this topic due to a lack of micro-level data.
This paper uses a new and comprehensive micro-credit dataset on euro-denominated overnight loans in the interbank market, analyzed at the lender-borrower level, during the periods surrounding the Lehman Brothers’ failure and the European sovereign debt crisis. By comparing loans made to the same borrower on the same day that differ only by whether the lender is a foreign or a domestic bank, the authors identify the cross-border effects that are masked when data is aggregated at the bank or country level. This approach helps identify the factors that contribute to the reduction in cross-border lending and assess to what extent nonstandard expansionary monetary policies help to mitigate cross-border frictions that inhibit the supply of credit.
- Crisis shocks reduce the supply of cross-border loans, as a foreign lender is less likely to grant an interbank loan than is a domestic lender. During the Lehman period, cross-border credit decreased by about 22.35 percent, while during the sovereign debt crisis credit availability was lower by about 12.59 percent.
- Even if a foreign lender grants an overnight interbank loan during a crisis period, the loan amount is reduced. When compared to domestic banks during the worst part of each crisis episode, foreign lenders reduced access to the same borrower on the same day: by 29 percent during the Lehman crisis and by 24 percent during the sovereign debt crisis, while loan volumes were reduced by 12 percent and by 10 percent, respectively. Cross-border spreads increased by 7 basis points during the Lehman shock, but during the European sovereign debt crisis, cross-border spreads only increased for borrow banks headquartered in the GIPS countries.
- During both crisis periods, the reduction of cross-border liquidity is independent of borrower-bank risk, including the risk associated with the country where the borrower bank is headquartered. This suggests a strong general flight to home effect during crisis times that is independent of the risk associated with an individual borrower bank.
- Nonstandard monetary policy improves the provision of interbank liquidity. During the Lehman-induced crisis, expansionary monetary policy improved the supply of cross-border credit by 29 percent. During the sovereign debt crisis, the ECB’s first intervention had no effect on the differential access in cross-border lending, but the second intervention improved credit supply by almost 59 percent compared to the conditions present during the week before this policy was enacted. Subsequent interventions, even if just boosting the confidence of financial markets, improved credit supply by almost 65 percent and by about 94 percent. This increase in available credit results in better access to loans, but does not exert a differential effect on the volume and spread for cross-border loans. Hence, while central bank intervention improved the supply of credit during crisis periods, these policies had a limited effect on promoting strong cross-border financial reintegration.
Banks with more cross-border loans in their asset portfolios tend to be substantially larger than those banks that focus their operations on domestic lending—hence, these larger banks play an important role in transmitting monetary policy and stabilizing the global financial system. The geographic segmentation of financial markets means that during crisis periods, without central bank intervention, the supply of interbank credit is greatly diminished, and this reduction may have broader economic consequences. During a crisis, unconventional monetary policy improves the supply of interbank credit, but exerts a limited effect on restoring the volume of cross-border lending that existed before the crisis. Further policies may be needed to restore international capital flows.
We analyze how financial crises affect international financial integration, exploiting euro area proprietary interbank data, crisis and monetary policy shocks, and variation in loan terms to the same borrower on the same day by domestic versus foreign lenders. Crisis shocks reduce the supply of crossborder liquidity, with stronger volume effects than pricing effects, thereby impairing international financial integration. On the extensive margin, there is flight to home—but this is independent of quality. On the intensive margin, however, GIPS-headquartered debtor banks suffer in the Lehman crisis, but effects are stronger in the sovereign-debt crisis, especially for riskier banks. Nonstandard monetary policy improves interbank liquidity, but without fostering strong cross-border financial reintegration.