What Are the Consequences of Global Banking for the International Transmission of Shocks? A Quantitative Analysis What Are the Consequences of Global Banking for the International Transmission of Shocks? A Quantitative Analysis

By José L. Fillat, Stefania Garetto, and Arthur V. Smith

Large banks with a global presence play an important role in the transmission of shocks across borders. The sheer size of foreign banking institutions and their involvement with the real economy makes them important vehicles for the global transmission of shocks. For example, foreign banks hold about 25 percent of the assets in the US banking system. The Japanese banking crisis of the early 1990s had a substantial effect on the credit supply in the United States. In this working paper, we find that after the 2010 European sovereign debt crisis, US branches of parent banks that were exposed to GIIPS sovereign debt (meaning the government debt in Greece, Ireland, Italy, Portugal, and Spain) cut their assets by 54 percent, representing roughly $427 billion and 8 percent of total US bank assets. In more recent related work, we estimate that an Italian sovereign or banking crisis in the current environment could cause a decline of as much as 20 percent in aggregate US bank assets.

Regulatory reforms should not only be reactive to crises, but also proactive to reduce the likelihood and limit the severity of such crises. A reform implemented in 1991 prohibited foreign branches from accepting uninsured retail deposits. Likewise, the financial crisis of 2008 and the 2010 European sovereign debt crisis prompted a wave of regulatory reforms that affected large banks in particular, including those with a global presence. For example, one of the provisions of the 2010 Dodd-Frank Act required foreign banks with more than $50 million in US subsidiary assets to consolidate all of their subsidiaries under a single bank holding company by 1 July 2016. This is known as the Intermediate Holding Company (IHC) requirement, and its goal was to mitigate the transmission of foreign shocks into the US credit markets. Incidentally, US branches owned by foreign banks were – and remain – exempt from this requirement, in the sense that assets held in branches did not count toward the $50 billion IHC threshold. As one may expect, foreign banks reacted strategically, implementing a series of changes in their operations and legal structures in response to the IHC requirements.

In this context, we develop a quantitative structural model of global banking that can be used to evaluate ex ante the effects of policy reforms. Our work contributes to the global banking literature in two important ways. First, while earlier contributions overlook the importance of a bank's mode of operations, our model provides a microfoundation for a bank's decision of whether and how to enter a foreign market – through branches or through subsidiaries. Second, while most studies employ reduced-form empirical analysis, our quantitative model enables us to study the cross-border effects of demand shocks and regulatory changes via comparative statics and counterfactual analysis, respectively.

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