By Hyun Song Shin
BANK LIABILITY AGGREGATES, INCLUDING SOME MONETARY AGGREGATES
Rapid growth of bank lending is mirrored on the liabilities side of the balance sheet by shifts in the composition of bank funding. As intermediaries who borrow in order to lend, banks must raise funding in order to lend to their borrowers. When credit is growing faster than the available pool of funds that are usually drawn on by the bank (“core liabilities”), the bank will turn to other, “non-core” sources of funding to support its credit growth.
In this way, the ratio of non-core to core liabilities serves as a signal of the degree of risktaking by the bank and hence of the stage of the financial cycle. Hahm, Shin and Shin (2013) conduct a cross-country panel probit study and find that the ratio of non-core to core liabilities (especially the non-core liabilities to foreign creditors) emerges consistently the most robust predictor of a currency crisis or credit crisis.
The distinction between core and non-core bank liabilities has a point of contact with monetary aggregates. Traditionally, the importance of monetary analysis for the realeconomy rested on a stable money demand relationship that underpinned the link betweenmoney and macro variables. Money demand is seen as the result of a portfolio decision of economic agents choosing between liquid and illiquid claims, whether based on an inventory holding of money for transactions purposes. For this reason, the traditional classifications of monetary aggregates focus on the transactions role of money as a medium of exchange.
However, unlike commodity money, monetary aggregates are the liabilities of banks and hence have an asset-side counterpart. Recognizing the asset-side counterpart of money and the determinants of bank lending focuses attention on the supply of money by banks. Indeed, rather than speaking of the demand for money by savers, we could turn the relationship on its head, and speak of the supply of funding by savers.
Similarly, by speaking of the supply of money as the demand for funding, the shift in the language serves to focus attention on the banking sector and its balance sheet management over the cycle.
However, monetary aggregates are traditionally measured by netting out claims between banks. For financial stability purposes, however, the claims between banks – especially when they are cross-border – take on great significance
Figure 4 plots the four-quarter growth in cross-border assets and liabilities of eurozone banks in euros. The destination of euro-denominated lending reached outside the eurozone, as eurozone banks expanded into central and Eastern Europe. However, the cross-border eurodenominated liabilities series in Figure 4 is can be seen as non-core liabilities generated through capital inflows. From 1999Q1 to 2008Q3, cross border liabilities rose almost 3.5- fold from 1.56 trillion euros to 5.4 trillion euros. This rapid spurt translates into a constant quarterly growth rate of 3.33%, which when annualized is close to 14%.
CORE AND NON-CORE LIABILITIES IN CHINA
However, what counts as “core” or “non-core” will depend on the financial system and the institutions. For economies with banks operating in developed, open capital markets, noncore funding will typically take the form of wholesale funding of the bank from capital markets, sometimes denominated in foreign currency. However, if the economy has a closed capital account, and when banks are prevented from accessing capital market funding from abroad, then what counts as non-core funding could be quite different.
Compare Korea and China. Figure 5 plots the monthly growth rates of various banking sector liability aggregates for Korea (in the left hand panel) and for China (in the right hand panel). The growth rates have been filtered through a Hodrick-Prescott filter at business cycle frequency. Note that the HP filter is used here with hindsight to highlight differences in time series patterns, not the real-time trend-finding exercise with the Basel III exercise.
In Korea, banks have access to capital markets, either directly or through the branches of foreign banks operating in Korea. For this reason, the most procyclical components of the bank liability aggregates are those associated with wholesale funding, especially the seriesfor the foreign exchange denominated liabilities of the banking sector.5 Before the 1997Asian financial crisis and the 2008 crisis, non-core liabilities grew rapidly, only to crash with the onset of the crisis. In contrast, the growth of M2, reflecting household and corporate deposits, is much less variable over the cycle.
However, the right hand panel of Figure 5 shows that in China, the sub-components of M2 show considerable variation in their time series properties, with corporate deposits showing the tell-tale procyclical patterns as compared to household deposits. For an economy such as China where banks are prevented from accessing international capital markets in the way that Korean banks do, applying the liability classifications from Korea into “core” and “non-core” would be inappropriate.
Instead, more thought is needed on how financial conditions are transmitted across the border into China. Just as water finds cracks to flow through, even a closed financial system cannot be immune to global financial conditions entirely. This is true especially for a highly tradedependent economy such as China. If the banks are prevented from accessing international capital markets, then the non-financial firms will be the conduit for the transmission of financial conditions.
Figure 6 depicts the activities of a Chinese non-financial firm with operations outside China, who borrows in US dollars from an international bank in Hong Kong and posts renminbi deposits as collateral in the China office of the bank. The transaction would be akin to a currency swap, except that the settlement price is not chosen at the outset. The transactions instead resemble the operation of the old London Eurodollar market in the 1960s and 70s. For the Chinese corporate, the purpose of having US dollar liabilities and holding the proceeds in renminbi may be to hedge their export receivables, or simply to speculate on renminbi appreciation. In practice, the dividing line between hedging and speculation may be difficult to draw.
Figure 7 provides the evidence for the transactions depicted above in Figure 6. Figure 7 plots the claims and liabilities of Hong Kong banks in foreign currency to customers in China. Foreign currency, in this case, would be US dollars (mainly) for the assets and renminbi (mainly) for the liabilities. Both have risen dramatically in recent years, reflecting the rapidly increasing US dollar funding of non-financial corporates.
The procyclical pattern in corporate deposits in the right hand panel in Figure 3 may be due to such activities of non-financial corporates. In addition, such activities of non-financial corporates may also explain why China has been experiencing dollar shortages in recent weeks with the deterioration of global funding markets due to the crisis in Europe. During this period the RMB has been under pressure, depreciating against the US dollar.
Although China’s banking system is largely closed, the global activities of its non-financial firms will be reflected in the corporate deposits within M2 when those firms hold the proceeds of dollar liabilities in their accounts in China.
Figure 8 illustrates the growth in the component of the money stock that is due to the deposits of corporates, rather than for households. The left panel shows the time trend in personal deposits and corporate deposits, while the right panel shows the ratio of the corporate to personal deposits. We see the increase in proportion of corporate deposits in recent years, consistent with the operations of Chinese corporates as shown in Figure 6.
The excess liquidity generated by the activity of non-financial corporates in China will be an important element of the lending boom in China, and is reminiscent of the lending boom in Japan in the 1980s following financial liberalization that allowed Japanese companies to access global capital markets.
Both in Japan in the 1980s and in China more recently, monetary aggregates, especially corporate deposits played the role of non-core liabilities in the way that FX borrowing by Korean banks plays the role of non-core liabilities in Korea.
The point of contact between the FX liabilities in Korea and the corporate deposits in China is that both are liability components of banks. Provided we have the correct demarcation between core and non-core liabilities, we can apply the same method of tracking the ratio of non-core to core liabilities as an indicator that can serve as early warning indicators of financial vulnerability.
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