Global Banking and Firm Financing: A Double Adverse Selection Channel of International Transmission

Board of Governors of the Federal Reserve System

International Finance Discussion Papers

Number 1325

August 2021

Global Banking and Firm Financing: A Double Adverse Selection Channel of

International Transmission

Leslie Sheng Shen

Please cite this paper as:

Shen, Leslie Sheng (2021). Global Banking and Firm Financing: A Double Adverse Selection Channel of International Transmission," International Finance Discussion Papers 1325. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/IFDP.2021.1325.

NOTE: International Finance Discussion Papers (IFDPs) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research sta or the Board of Governors. References in publications to the International Finance Discussion Papers Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers. Recent IFDPs are available on the Web at www.federalreserve.gov/pubs/ifdp/. This paper can be downloaded without charge from the Social Science Research Network electronic library at www.ssrn.com.

Global Banking and Firm Financing: A Double Adverse Selection Channel of International Transmission

Leslie Sheng Sheny

Federal Reserve Board of Governors

April 2021

Abstract

This paper proposes a "double adverse selection channel" of international transmission. It shows, theoretically and empirically, that financial systems with both global and local banks exhibit double adverse selection in credit allocation across firms. Global (local) banks have a comparative advantage in extracting information on global (local) risk, and this double information asymmetry creates a segmented credit market where each bank lends to the worst firms in terms of the unobserved risk factor. Given a bank funding (e.g., monetary policy) shock, double adverse selection affects firm financing at the extensive and price margins, generating spillover and amplification effects across countries.

An earlier draft of the paper was circulated under the title "Global vs. Local Banking: A Double Adverse Selection Problem." I am grateful to Pierre-Olivier Gourinchas, Ulrike Malmendier, Yuriy Gorodnichenko and Annette Vissing- Jorgensen for invaluable advice and guidance. I also would like to thank Carlos Avenancio-Leon, Thorsten Beck, Satoshi Fukuda, Linda Goldberg, Galina Hale, Rebecca Hellerstein, Sebnem Kalemli-Özcan, Amir Kermani, Ross Levine, Robert Marquez, Ben Moll, Damian Puy, Jonathan Ragan-Kelley, Nick Sander, Neeltje van Horen, Ganesh Viswanath-Natraj, Michael Weber, James Wilcox, and seminar participants at the Federal Reserve Bank of New York, Federal Reserve Board, George Washington University, London School of Economics, University of Maryland, Santa Clara University, UC Berkeley Economics and Haas, University of British Columbia, University of Pittsburg, the ECB Forum on Central Banking, CEBRA International Finance and Macroeconomics Meeting, Norges Bank Workshop on Frontier Research in Banking, Emerging Scholars in Banking and Finance Conference, and the annual meeting of the American Economics Association for helpful comments. Michael Nguyen-mason, Yingjie Wu, Lisa Zhang, and Qin Zhang provided excellent research assistance. This work is supported by research funding from the Clausen Center. The views in this paper are solely the responsibility of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or any other person associated with the Federal Reserve System.

• Shen: Federal Reserve Board, 20th and C Streets NW, Washington, D.C. 20551 (email: [e-mail]).

• Introduction

How economic and financial shocks transmit across countries is a fundamental question in international finance. A growing body of literature has pointed out that global banks-banks that lend to foreign entities through cross-borderloans-play a key role in transmitting shocks abroad.1 Indeed, the past two decades have seen an explosion in cross-border lending by global banks: global banking loans have more than tripled since the mid-1990s, reaching almost $15 trillion and accounting for around 20% of total domestic private credit for an average developed or major emerging market economy (Appendix Figure B.1). Existing literature mostly studies the role of global banks in transmitting shocks by tracing changes in the credit they supply in response to monetary policy and liquidity shocks.2 In contrast, this paper delves into the economic mechanism that explains how global banking credit is allocated across firms in the first place, and shows that the underlying mechanism generates a new channel of international transmission.

I propose an information view of credit allocation in financial systems with both global and local banks. I show, theoretically and empirically, that bank specialization in global versus local information constitutes a key mechanism driving credit allocation across firms in such globalized financial systems. Global banks specialize in information on global risk factors, and local banks specialize in information on local risk factors. This micro-foundation reveals a problem of double adverse selection in credit allocation: each bank type lends to the worst firms in terms of the risk characteristic it does not specialize in. This double adverse selection gives rise to a new channel of international transmission: when one bank is hit with a funding shock (e.g., monetary policy shock), firm financing is affected at both the extensive and intensive (interest rate) margin, generating spillover and amplification effects through adverse interest rates-a "double adverse selection channel" of international transmission.

The information view of credit allocation builds on a long-standing literature in banking highlighting that the special role of banks derives from their ability to collect and process information, which is key in determining bank-firm relationships (Campbell and Kracaw 1980, Diamond 1984, Ramakrishnan et al. 1984, and Boyd and Prescott 1986). I show, however, that the traditional theory is not sufficient to explain bank-firm sorting in a globalized financial

• See, among others, Cetorelli and Goldberg (2012a), Schnabl (2012), De Haas and Lelyveld (2014), Rey (2016), Bräuning and Ivashina (2020), Ongena et al. (2017), Miranda-Agrippino and Rey (2018), Morais et al.
  (2018),Takáts and Temesvary (2020), and Baskaya et al. (2021).
  2 Existing literature shows that, following monetary policy shocks, global banks adjust cross-border flows to other countries through both external capital markets and internal capital markets, increasing the international propagation of domestic liquidity shocks. Morais et al. (2018) find that US and European global banks increases the supply of credit to Mexican firms following a softening of monetary policy at home. Cetorelli and Goldberg (2012a) show that global banks actively use internal capital markets to reallocate funds between the head office and their foreign offices in response to monetary policy shocks.

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system with both global and local banks. The traditional theory posits that banks and firms sort based on hard and soft information: large banks are more likely to lend to firms with more readily available hard information, which tend to be large and established firms, while small banks are more likely to establish relationships with firms with more soft information, which tend to be small and young firms. Mapping this theory to the context of bank-firm sorting in globalized financial systems,3 one would conjecture that global banks are more likely to lend to firms with more hard information, since global banks tend to be larger than local banks. However, using a detailed bank-firmloan-level dataset spanning across 24 countries, I find that both global and local banks lend to firms across the entire asset size and age distribution. This finding points to a puzzle in the mechanism driving the allocation of global banking credit across firms: why do firms of similar size and age borrow from different types of banks?4

In light of this puzzle, I raise a new perspective. I conjecture that global and local banks differ in their specialization in global and local information: global banks have a comparative advantage in extracting information on global risk factors, and local banks have a comparative advantage in extracting information on local risk factors. Each bank type's comparative informational advantage plays a key role in determining bank-firm sorting in financial systems with both bank types. This idea is motivated by the observation that global banks are uniquely positioned to extract information on global factors through global market making activities and research efforts within the banking organizations.5 At the same time, local banks are more conveniently positioned to extract information on local factors through local lending relationships (Petersen and Rajan 1994, Berger et al. 2005).

To analyze and test the conjecture, I first develop a model to formalize the new perspective and derive empirical predictions. I specifically focus on the prediction for bank-firm sorting in globalized financial systems and the implication for international transmission of bank funding shocks. I then test the model predictions using detailed cross-countryloan-level data and empirical strategies that tightly maps to the model set-up.

The model features an economy comprised of global and local banks, and firms that have returns dependent on global and local risk factors. The key ingredient of the model is each bank type's comparative informational advantage: global banks have the technology to extract

• Globalized financial systems here refer to markets comprised of global and local banks as well as firms
  with access to both banks, which tend to be firms above a certain size threshold.
  4 Another mechanism we may conjecture driving the sorting may be bank specialization in loans of par- ticular currency denominations. I provide evidence in Section 2 showing that, in fact, global and local banks
  lend in both local and non-local currencies.
  5 For instance, global banks heavily recruit PhD economists to work in their macro research departments. See past and current job listings from global banks such as Citi, JP Morgan, and Goldman Sachs on the American Economic Association's Job Openings for Economists site: https://www.aeaweb.org/joe/listings.

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information on global factors but not local factors, and vice versa for local banks. This double information asymmetry is common knowledge and thereby incorporated in both the banks' loan contract pricing and the firms' selection of lenders. Each bank prices loans based on the component of firm return it observes, as well as its expectation of the component of return it does not observe for the subset of firms that selects the respective bank. Each bank type holds Nash-type conjectures about the other bank type's loan pricing and plays best response strategies. The equilibrium features a fixed-point solution where each bank offers the best rate to the firms that select into that bank.

The model generates a sharp prediction about credit allocation across firms: firms with higher expected return based on global factors relative to local factors are more likely to borrow from global banks, and vice versa for firms with returns more dependent on local factors. This allocation reveals a problem of double adverse selection: both global and local banks are adversely selected against by the firms, as firms select into borrowing from the bank which observes the more favorable component of their returns. In other words, each bank lends to the worst firms in terms of the unobserved characteristic.

I further demonstrate that the double adverse selection problem generates a double adverse selection channel of international transmission through which bank funding shocks are transmitted to foreign (and domestic) firm financing. When one of the banks is hit with a funding (e.g., monetary policy) shock, the double adverse selection affects credit allocation at both the extensive and intensive margins, generating spillover and amplification effects through adverse interest rates.

Specifically, suppose global banks face a decrease in funding cost due to expansionary monetary policy in the home country of the global banks. At the extensive margin, the model predicts that firms with relatively balanced global and local risk exposure components are more likely to switch into contracting with global banks. The result is driven by double adverse selection: since the firms with relatively balanced global and local risk exposure receive the most adverse interest rates relative to the first-best outcome, they are more likely to switch lenders given any changes in the credit market. These marginal firms that switch away from local banks into global banks are less risky than the infra-marginal firms that continue to borrow from either the local banks or the global banks.

At the intensive margin, the model predicts that i) the interest rates of the infra-marginal firms that remain with the local banks are expected to increase (i.e., a spillover effect), and ii) the interest rates of the infra-marginal firms that remain with the global banks are expected to decrease by more than the direct effect caused by the funding cost change (i.e., an amplification effect). The spillover effect on the infra-marginal firms that continue to borrow from local banks is solely driven by an exacerbation of the adverse selection problem. Since the marginal

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