by RN McCauley · 2017 · Cited by 95 — 4 In this paper, we show that this decline is driven by changes in only certain banks’ balance sheets, and is thus not evidence of a broad-based deglobalisation

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BIS Working PapersNo 650 Financial deglobalisation in banking? by Robert N McCauley, Agustín S Bénétrix, Patrick M McGuire and Goetz von Peter Monetary and Economic Department June 2017 JEL classification: F36, F4, G21 Keywords: Financial globalisation, international banking; consolidation; ownership

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BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website ( © Bank for International Settlements 2017. A ll rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISSN 1020-0959 (print) ISSN 1682-7678 (online)

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WP650 Financial deglobalisation in banking? i Financial deglobalisation in banking? Robert N McCauley, Agustín S Bénétrix, Patrick M McGuire and Goetz von Peter 1 Abstract This paper argues that th e decline in cross-border banking since 2007 does not amount to a broad-based retr eat in international lending (fifinancial deglobalisationfl). We show that BIS international banking data organised by the nationality of ownership (ficonsolidated viewfl) provide a cl earer picture of international financial integration than the traditional balance-of-payments measure. On the consolidated view, what appears to be a global shrinkage of international banking is confined to European banks, which uniquely respon ded to credit losses after 2007 by shedding assets abroad Œ in particular, reducing lending Œ to restore capital ratios. Other banking systems™ global footprint, notably those of Japanese, Canadian and even US banks, has expanded since 2007. Using a global dataset of banks™ affiliates (branches and subsidiaries), we demonstrate that the who (nationality) accounts for more of the peak-to-trough shrinkage of foreign claims than does the where (locational factors). These findings suggest that th e contraction in global lend ing can be interpreted as cyclical deleveraging of European banks™ large overseas operations, rather than broad-based financial deglobalisation. Keywords: Financial globalisation, internat ional banking; consolidation; ownership JEL classification: F36, F4, G21. 1 Bank for International Settlements (BIS), Trinity College Dublin, BIS and BIS, respectively. The authors thank Claudio Borio, Jaime Caruan a, Ingo Fender, Philip Lane, Swapan Pradhan, Hyun Song Shin, Philip Wooldridge, Charles Wyplosz, and participan ts in a BIS seminar for comments. We thank Jakub Demski, Pablo Garcia-Luna and Jose Maria Pastor Vidal for research assistance. The views expressed are those of the authors and not necessarily those of the Bank for International Settlements or Trinity College Dublin.

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WP650 Financial deglobalisation in banking? iii Contents Abstract . .. i 1. Introduction 1 2. The analytics and empirics of consolidation . 3 3. The view by bank nationality .. . 8 4. European bank deleveraging with home bias .. 10 5. Deglobalisation and the nationality effect .. 12 5.1 The interplay between bank na tionality and location 12 5.2 Identifying the nationality effect .. 14 6. Conclusions .. 20 References .. . 21 Previous volumes in this series .. 25

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2 WP650 Financial deglobalisation in banking? Such filocationalfl measures of external assets suffer from two limitations: double- counting some positions and ignoring other relevant ones. As a result, they do not best serve to assess globalisation trends in banking. To be sure, giving priority to where the banking business is conducted (n ot by whom), as the BIS locational statistics do, can be useful in analys ing macroeconomic aggregates, such as employment and value added. 6 But cross-border claims double-count positions in which a bank™s headquarters funds its branch in a financial centre like London, before lending abroad. At the same time, a bank™s local positions booked in an affiliate abroad (eg a UK bank™s loan to a French resident through the bank™s Paris branch) are not captured in the external positions of either the bank™s home country or the affiliate™s host country. On a consolidated view, these are foreign positions Œ the bank has lent to a borrower outside the home country, even if it is booked and funded locally. And bank positions by location rather than by ownership cannot be related to the financial strength of particular banks or to the policies of the banks™ home government or supervisors. As a result, this perspective has little to say on the drivers of (de)globalisation. In this paper, we take multinationa l banks aggregated by the country of headquarters as the unit of analysis. By an alogy to work on multinational firms, we fidraw borders around groups of firms cla ssified by nationality rather than around geographical entitiesfl (Baldwin et al (1998) , Avdjiev et al (2016)). We examine the foreign claims of 29 banking systems th at report the BIS consolidated banking statistics (CBS) for evidence of deglobalisation. 7 We contribute to a growing body of wo rk that puts the emphasis on banks™ consolidated balance sheets rather than on locational (cross-border) bank positions. Much of this literature focuses on the effect of capital constraints on banks™ foreign lending. In particular, McCauley and Ye aple (1994) and Peek and Rosengren (1997, 2000) analysed their effect on Japanese banks™ lending abroad. McGuire and Tarashev (2008) analysed their effect on lending to emerging markets. Avdjiev et al (2012) analysed their effect on European bank s™ lending in central and eastern Europe. Forbes et al (2017) found that both hi gher required capital and monetary policy incentives for domestic lending led UK banks to cut loans abroad. 8 In recent papers close to ours, Cerutt i and Claessens (2017) found that equity market indicators of bank vulnerability drov e the banks™ retrenchment after the crisis, though more through a contraction in cross-border than in local lending. In related work, Cerrutti and Zhou (2017) show that, in spite of the shrinkage of cross-border credit from core lenders, the network continued to prolif erate linkages. They describe their findings as consistent with th e speech that anticipated this paper (Caruana (2017b)), which regards financial deglobalisation as a regional (European) phenomenon. Bouvatier and Delatte (2015) use a traditional gravity model with a non-linear time trend to assess integrat ion, and highlight the contraction of consolidated assets of banks hea dquartered in the euro area. Our paper contributes to this body of work in three ways. First, in Section 2 we analyse step-by-step the di fferences in locational an d consolidated measures of 6 See Borio (2013) and Tissot ( 2016) on the complementary nature of measures base d on ownership and geography. 7 See Goodhart (2011, pp 100-103) on the origins of internationa l cooperation in consolidated supervision in the late 1970s and Caruana (2017a ) on the collection of consolidated data. 8 By contrast, Cetorelli and Goldberg (2011) examined funding shocks.

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WP650 Financial deglobalisation in banking? 3 deglobalisation. At the global level, thes e differences happen to cancel each other out. But a focus on ownership reveals which banks by nationality retrenched after the crisis. Sections 3 and 4 show that the shrinka ge of cross-border claims around the world originates in Europe. Banks headqu artered in other advanced economies (eg Japan, Canada, Australia and even the United States) have continued to deepen their global financial integration. European ba nks uniquely restored their capital ratios through asset shrinkage, and foreign claims bore the brunt of it, pointing to home bias. A retreat to the home market when a bank has suffered losses can reflect lower expected returns abroad or increased risk av ersion (Giannetti and Laeven (2012)). But it can also reflect policy choices in the context of government support for banks (Rose and Wieladek (2014) and unconventional monetary policy that targets domestic lending (Forbes et al (2017)). Though cons olidated European banks have retrenched, they have slashed assets disproportionately outs ide of their home offices. Finally, in Section 5 we run a formal ho rserace between bank nationality and the effects of local economic conditions and policy measures in accounting for global bank retrenchment. This uses data that si multaneously capture bank nationality and bank location (eg German banks in German y as separate from German banks in the United Kingdom). Nationality effects Œ agai n highlighting European banks Œ account for more of the decline in total foreign asse ts and in cross-bor der lending than do locational factors. Moreover, those global consolidated banking systems that suffered greater credit losses during and following th e GFC tended to shrink their cross-border credit by more, in many locations around th e world. European banks™ problems thus reverberated globally. In sum, European bank retrenchment is better interpreted as a cyclical deleveraging of unsustainably risky bank balance sheets than a secular deglobalisation trend. Specifically, those bank ing systems that relied on a strategy of asset shrinkage to cope with heavy credit losses during the crisis shed their foreign claims in the wake of the crisis. Crucially, these results do not co me to light under the traditional locational perspectiv e, but require consolidation. 2. The analytics and empirics of consolidation Three reasons motivate building our disc ussion of deglobalisation on globally consolidated data. The first is that consolidated data incl ude one dimension entirely absent from the residence-based (locationa l) perspective, namely banks™ local positions in host countries around the world. Cross-border ownership is as much an expression of globalisation as cross-border positions . Second, consolidation removes intragroup positions, and thus avoids double-counting foreign claims that banks fund this way. And third, banking data organi sed by nationality of ownership provide a clearer picture of financial integration: the assignment of (arm™s length) cross-border positions to bank nationalities leaves unc hanged the global aggregate, but this step is essential for understanding how these positions respond to bank characteristics and the policies of the home government or supervisory authorities. To illustrate these points, start from th e locational perspective. A country™s external bank assets include too much and too little from a nationality perspective. For the United States, when resident non-US banks™ branches ra ise dollars from US

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4 WP650 Financial deglobalisation in banking? money market funds and lend them ab road (Baba et al (2009)), then the corresponding US external a sset (a claim entering the US international investment position) is not held by a US-owned bank. From a nationality perspective, this is too much Œ the non-US bank branch should be consolidated with its foreign parent. Similarly, when a US bank books an intrag roup claim on its London branch, it does not have a claim on a foreign entity, although US external assets rise. This, too, is too much from a nationality perspective. Howeve r, when a US-owned bank affiliate in London accepts a deposit from a central ba nk (ie of foreign exchange reserves) and lends it to an emerging mark et firm, this is not recorded as a US external asset. From a nationality perspective, this is too little. Clearly, consolidation has two distinct aspe cts. The first is to boil down a complex array of balance sheets into a single balance sheet that nets out intragroup balances but also adds in positions b ooked in offices abroad. The se cond is the assignment of this unified balance sheet to a particular home country. We use the location of a bank™s headquarters. One can imagine other choices Œ for some purposes one might wish to drill down to the underlying equity holders, for instance. 9 The reduction process nets out intragroup positions, the flu ff of international finance, but adds in offshore positions against unaffiliated parties, the stuff of international finance. If a bank in A routes loans to B through C, perhaps an offshore financial centre, consolidation strikes A™s claim on C and C™s claim on B and reports just A™s claim on B (Table 1) . Likewise, with B™s claims on A routed through C. From the perspective of risk exposure, the impo rtance of consolidation is immediately apparent if one imagines something going wrong in B, leaving bankers and policymakers in A wondering what their exposure to th e adverse event might be. Similarly, consolidation is useful to those in B, making clear that the ultimate lender and decision-maker is in A, not C. Consolidation of positions in offshore ce ntres not only redistributes positions, but can also reduce them in aggregate. For example, the global Lane-Milesi-Ferretti (LMF) ratio Œ total external positions divided by global GDP Œ in Table 1 is 9 Particular cases can challenge this assignment by headquarters Š think of BCCI, incorporated in Luxembourg but headquartered in the United Kingdom (Goodhart (2011); Bori o and Filosa (1994). External and consolidated bank position s: the case of the offshore centre Alternative measures of international financial integration Table 1 Country A (GDP = 100) Country B (GDP = 100) Offshore centre C (GDP = 10) Global total Positions Assets Liabilities Sum Assets Liabilities Sum Assets Liabilities Sum External 100 due from C 100 due to C 200 100 due from C 100 due to C 200 200 due from A,B 200 due to A,B 400 800 Consolidated 100 due from B 100 due to B 200 100 due from A 100 due to A 200 0 0 0 400 Memo: LMF ratio 200% 200% 4,000% 381% Consolidated ratio 200% 200% 0 190% Source: Authors.

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WP650 Financial deglobalisation in banking? 5 (200+200+400)/(100+100+10) = 800/210, or almo st 400%. But much of this is fluff and the consolidated aggregate openness is 400/210, or just under 200%. Intragroup positions are big money. Of th e $27 trillion in cross-border claims in the fourth quarter of 2016, about $9 trillion was intragroup claims ( In other words, a third of external bank claims (ie those compiled on a balance of paym ents basis) are consolidated away. If a bank uses an offshore centre to rais e deposits and lend to unaffiliated parties, then consolidation in effect relocates that activity to the home country. Recall the case of the US bank affiliate in London accepting a deposit of foreign exchange reserves and lending it abroad. In this case, consolidated accounts would show a smaller UK balance sheet and a larger US balance sheet, with no effect on the aggregate LMF ratio. Finally, consolidation brings into view pu rely local positions that are not captured at all in external assets. On a consolidated view, these are foreign positions – the bank headquartered abroad has liabilities to a ho st depositor, and credits to host country borrowers. The simplest possible example is a two-country world of like-sized (GDP = 100) economies with similar ex ternal positions (Table 2). Ex ternal assets of 100 plus external liabilities of 100 put gross external positions at 200% of GDP for each country and the world (first memo item, the LMF ratio). In addition, each country™s banks have branches in the other country that attract local deposits and extend credit to the extent of 50. Thus, on a consolidated view, A™s banks have 50 more in foreign assets and 50 more in foreign liabilities booked at their branches in B, and B™s banks have 50 more in foreign liabilities and 50 more in foreign assets booked at their branches in A. A™ s banks have foreign assets plus foreign liabilities equal to 300; sim ilarly, B™s banks, 300. Consolidated openness is 300% of GDP for each countr y and the world. Thus, in principle, consolidation has an ambivalent effect on measured international financial integration. If the multiplication of intragroup positions through offshore financial centres dominates, the locational measure could overstate External and consolidated bank positions with local positions Alternative measures of international financial integration Table 2 Country A (GDP = 100) Country B (GDP = 100) Global total Positions Assets Liabilities Sum Assets Liabilities Sum External 100 due from B 100 due to B 200 100 due from A 100 due to A 200 200 + local branch 50 due from B 50 due to B 100 50 due from A 50 due to A 100 100 = Consolidated 150 due from B 150 due to B 300 150 due from A 150 due to A 300 300 Memo: LMF ratio 200% 200% 200% Consolidated ratio 300% 300% 300% Source: Authors.

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