Was the Worldwide Use of Wholesale Funds Important for the International Transmission of the US Subprime Crisis?

Financial crisis
Financial Economics

The magnitude and reach of the recent financial crisis, several orders of magnitude larger than the size of the initial shock to the US subprime sector, has led many to wonder how a shock to a seemingly small segment of the US financial market managed to propagate so much, so fast. Although a real channel through trade linkages with the US has undoubtedly played a role in the international transmission of the crisis (Levchenko et al. 2009), the timing of some of the events strongly suggests that the first line of action took place through international financial linkages. For instance, the bank run on Northern Rock took place in September 2007, only one month after the beginning of the crisis in the US and when the US economy had not started to shrink yet.

Among possible sources of financial linkages, the increasing worldwide reliance of financial institutions on short-term wholesale funds has captured a lot of attention as a likely major contributor to the spread of the malaise. There are three basic reasons for this attention. First, the crisis resulted in a sharp and widespread collapse in US wholesale and interbank market funds (Brunnermeier, 2009; Gorton, 2009). Second, interbank markets have become increasingly connected, so the contraction in interbank lending was not limited to the US, but it was a worldwide decline in liquidity provision (Acharya and Merrouche, 2009; Brunetti et al. 2009). Third, financial institutions worldwide have increasingly relied on wholesale funding to supplement demand deposits as a source of funds, becoming, therefore, vulnerable to a sudden dry up of them. The two panels of Figure 1 show the evolution of interbank spreads during the crisis in 6 countries (Panel A), and the increase in the use of wholesale funds by banks worldwide before the crisis started (Panel B).

The combination of these three ingredients could explain the global spread of distress across the financial sectors of different countries, particularly across their banking sectors. In fact, although the earlier literature emphasized the benefits of these alternative sources of financing (Feldman and Schmidt, 2001; Calomiris, 1999), some also raised voices of concern about the implications of this liability structure for systemic vulnerability. For instance, Rajan (2006) noted that banks’ greater reliance on market liquidity makes their balance sheets more suspect in times of crisis, and Demirguc-Kunt and Huizinga (2009) found that a bank’s reliance on non-deposit sources of funds increases its risk. These concerns increased as the ongoing financial crisis unfolded, and various papers and publications have recently suggested that banks’ reliance on wholesale funds was behind the failure of some institutions (Brunnermeier, 2009; Shin, 2009; and Dewatripont, Rochet, and Tirole, 2010, among others). In fact, The Economist (2008), citing Citigroup analysts stated that: “A growing number of banks are being subjected to a wholesale version of a bank run, with access to wholesale funding evaporating in a matter of days, if not hours”.

Did the reliance on wholesale funds by banks worldwide play an independent role in the transmission of these liquidity crunches? Recent research where I study the impact of the liquidity crunch following the bankruptcy of Lehman Brothers on September 15, 2008 on the stock-price returns of individual non-US banks worldwide indicates that it did (Raddatz, 2010).

The banking sector as a whole experienced a large decline in stock prices following Lehman’s bankruptcy, but even within the same country, some banks were much more affected than others. In Raddatz (2010), I use the differences in the stock price response of 664 banks in 44 countries to the liquidity crunch to uncover evidence of the likely mechanisms of transmission using an event study methodology. Finding that, after controlling for other channels, banks that relied more heavily on wholesale funds were more affected by the liquidity crunch evidences that the use of these funds helped propagate the shock.

The results confirm that, even after accounting for the overall decline in stock market prices, the banking sector across the world experienced a large and significant abnormal return decline following this event. Banks’ returns worldwide declined about 2.9 percent in the three days after Lehman, as seen in Figure 2 that shows the cumulative abnormal returns of the average bank in a 10-day window around the Lehman event.

Most important, banks that before the crisis relied more heavily on wholesale funding experienced a larger abnormal return decline in response to US events than other banks. In the days following Lehman, the returns of banks with high wholesale dependence (75th percentile, corresponding to an 87.1 percent of total liabilities in non-retail deposits) declined 2 percent more than those with low wholesale dependence (25th percentile, 41.6 percent of non-retail deposits), controlling for the riskiness of their balance sheet, their size, and their direct exposure to the bankruptcy. The cumulative abnormal returns in Figure 3 show this difference. The difference is significant and large. It corresponds to two-thirds of the average stock price decline of the banking sector (see Figure 2, above), implying that differences related to the use of wholesale funds are of the same order of magnitude than the large average decline observed in the data. The widespread use of wholesale funds can explain an important fraction of the early global transmission of this event, confirming that the reliance on these types of funds played a significant role in the propagation of the financial crisis.

The size of a bank and its exposure to Lehman also explain the differential response of banks worldwide to this episode (see Figure 4). Larger banks were less affected than smaller ones, consistently with larger institutions being considered as safer than smaller ones, perhaps for being “too big to fail” and enjoying implicit government support. On the contrary, investment banks, and banks directly exposed to Lehman did relatively worse than the rest of banks. Apparently, the failure of Lehman leads investors to question the business model of investment banks, and to consider all of them as more risky counterparties. Banks directly exposed to Lehman were mechanically affected by its failure, but within these banks, those with higher use of wholesale dependence performed relatively worst. To a lesser extent, banks that were more profitable before the crisis (controlling for risk) did also relatively better. Somewhat surprisingly, more leveraged banks did not seem to have done significantly worse than the rest.

In addition to validate the role of wholesale funds in the transmission of the crisis, an interesting aspect of these results is that they show that, even amidst the chaos following the bankruptcy of Lehman Brothers, markets were still able to discriminate among banks in a manner that is relatively consistent with fundamentals. The observed pattern of abnormal returns, and its relation to different sources of risk, is not simply that of an indiscriminate decline on the global banking sector.

The distress caused by Lehman on wholesale-dependent banks not only affected stock prices but also resulted in a contraction of their lending activity, indicating that this source of vulnerability had consequences for the real economy (Figure 5). Between the end of 2007 and 2008, bank loans in the 44 countries considered in Raddatz (2010) declined in about 2 percent, but, within the same country, loans in a bank with high wholesale dependence (75th percentile) declined 0.7 percent more than in a bank with low wholesale dependence. This is consistent with the decline in aggregate lending activity in countries suffering a larger loan supply shock documented by Cetorelli and Goldberg (2009).

Further exploratory evidence suggests that some country characteristics, such as the coverage of deposit insurance or its degree of capital account openness, may reduce the vulnerability of wholesale dependent banks to liquidity crunches, while other characteristics such as the exposure of a country to the US  may amplify it.
These results highlight yet another dimension of the typical trade-off between efficiency and vulnerability involved in financial integration, but one that relates to the vulnerability of the banking sector, which plays a key role in the normal functioning of an economy. A well-developed wholesale interbank market may help to efficiently allocate liquidity across institutions, to boost returns, and to deal with maturity mismatches, but these linkages also expose banks worldwide to a common source of fluctuations and may reduce banks’ incentives to hold liquidity (Castiglionesi et al., 2009). 

The results also indicate that the increased reliance of banks worldwide on wholesale sources of funds was an independent and qualitatively and quantitatively important channel for the international transmission of the crisis. This suggests that further thought is required on the relative safety of different sources of banks’ funds.  While demand deposits have historically being considered risky and received government insurance, other sources of funds have not. Yet, during this crisis, their systemic nature became apparent and governments had to extend protection to them too. These results strengthen the case for the explicit consideration of the risks associated with the liability structure of banks in the discussions on regulatory reform, as recently suggested by several authors (Brunnermeier et al., 2009; Perotti and Suarez, 2009). 

Investors also considered smaller banks and those exposed to Lehman (through the business model or through assets) as more risky and acted accordingly. Thus, too-big-to-fail and counterparty risk considerations seem to have also played a role in the propagation of the distress resulting from Lehman’s bankruptcy. This indicates that amidst the chaos, investors were still able to discriminate among banks in a manner that is consistent with fundamentals. Contrarily to some discussions in the press, even in these turbulent conditions, markets were not purely panic driven and seem to be able to process some information.


Figure 1 – Interbank Spreads and Use of Wholesale Funds Panel A shows the evolution of the Ted Spread during 2006-2010 for several countries (difference between the 3-month LIBOR in each country’s currency and its T-Bill rate). Panel B shows the average non-deposit liabilities across all banks reporting to Bankscope during the 2001-2006, five-year period.


Figure 2 – Global Banking Sector The figure shows the cumulative abnormal return of the global banking sector in a window of ten trading days before and after Lehman Brothers filed for bankruptcy on September 15, 2008.  


Figure 3 – Banks with High and Low Wholesale Dependence The figure shows the cumulative abnormal return of banks with high and low dependence on wholesale funding in a window of ten trading days before and after Lehman Brothers filed for bankruptcy on September 15, 2008. The results come from a specification that controls for banks’ size, profitability, leverage, declared exposure to Lehman, and investment bank status.


Figure 4 – Other Relevant Bank Characteristics The figure compares the cumulative abnormal return of large and small banks (Panel A), banks that declared exposure to Lehman versus the rest (Panel B), and investment banks versus commercial banks (Panel C). The results come from specifications that controlled for leverage, and profitability (not significant). All CAR correspond to a window of ten trading days before and after Lehman Brothers filed for bankruptcy on September 15, 2008.  


Figure 5 –Wholesale Dependence and Loan Growth The figure shows the partial regression between a bank’s measure of wholesale dependence and its growth on loans between the last balance sheet reported before Lehman’s bankruptcy and the fist balance sheet reported after this event. Growth rates are reported in percentages. The regression controls for country fixed-effects, (log) initial loans, leverage, assets size, profitability (ROA), an investment bank dummy, and a dummy for banks that declared exposure to Lehman.



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