VoxEU Column Global crisis

How important was the worldwide use of wholesale funds for the international transmission of the US subprime crisis?

How did a seemingly small shock to the US financial markets manage to spread so far, so quickly? This column argues that the heavy reliance on short-term wholesale funding is to blame. It follows that the discussions of regulatory reform should focus on the risks associated with the liability structure of banks.

The global scale of the financial crisis begs the question: How could a shock to a seemingly small segment of the US financial market spread so far, so quickly? Although trade links with the US have undoubtedly played a role (Levchenko et al. 2009), the timing of some of the events strongly suggests that the first route of transmission was through the web of international finance. Take the bank run on Northern Rock in September 2007, this took place only one month after the beginning of the crisis in the US and when the US economy had not yet started to shrink.

Among possible sources of financial linkages, the increasing worldwide reliance of financial institutions on short-term wholesale funds has been frequently mentioned as a likely major contributor to the spread of the malaise.

Financial institutions worldwide have increasingly relied on wholesale funding to supplement demand deposits as a source of funds, therefore becoming vulnerable should they suddenly dry up. Although earlier studies have emphasised the benefits of these alternative sources of financing (Feldman and Schmidt 2001, Calomiris 1999), some have recently raised concern about the implications of this liability structure for systemic vulnerability.

Dangerous dependence

Raghuram Rajan (2006) for instance, noted that banks’ greater reliance on market liquidity makes their balance sheets more suspect in times of crisis. In line with this, Demirguc-Kunt and Huizinga (2009) have found that a bank’s reliance on non-deposit sources of funds increases its risk. These concerns increased as the ongoing financial crisis started to unfold, and recently various papers and publications have suggested that banks’ reliance on wholesale funds may be behind the failure of some institutions. For instance, 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”.

The increased worldwide reliance on wholesale funds was compounded by the fact that one of the most outstanding developments of this crisis was a sharp and widespread collapse in liquidity provision (Acharya and Merrouche 2009, Brunetti et al. 2009). This collapse took place in two stages:

  • first at the beginning of August 2007, immediately after BNP Paribas ceased redemptions in three of its funds, and
  • second, and most importantly, in mid September 2008, following Lehman Brothers bankruptcy filing and the announcement of the US government bailout of AIG.

This can be clearly seen in Figure 1 that shows the sharp increases in the TED and LIBOR-OIS spreads around these dates. These sharp contractions in liquidity provision have been the focus of recent research that has proposed explanations based on the interaction between margin calls and market liquidity, the cyclicality of leverage, and the role of Knightian uncertainty (Brunnermeier 2009, Adrian and Shin 2009, Caballero 2009a, Caballero 2009b, and Caballero and Krishnamurthy 2008). In fact, although the ongoing crisis was initially dubbed the “subprime crisis” some authors have referred to it as the “liquidity crunch of 2007-2008” (Brunnermeier 2009).

Figure 1. Ted spread and LIBOR-OIS spread


Note: The figure shows the Ted Spread (difference between the 3-month US LIBOR and US T-Bill rate) and the LIBOR-OIS Spread (difference between the 3-month US LIBOR and the overnight interest swap rate). The dashed lines are dated August 9, 2007, and September 15, 2008.

New insight on the destructive role of wholesale funding

Did the increased reliance on wholesale funds by banks worldwide play a role in the transmission of these “liquidity crunches”? In recent research (Raddatz 2010), I use the example of the fallout from the Lehman Brothers bankruptcy to argue that it did.

The banking sector as a whole experienced a large decline in stock prices following this episode, but even within the same country, some banks were much more affected than others. 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. Banks that relied more heavily on wholesale funds were more affected by the liquidity crunch. This suggests that the wholesale funds helped spread the shock.

Even after accounting for the overall decline in stock market prices, the global banking sector experienced a large and significant abnormal decline in returns following this event. Figure 2 shows that banks’ returns worldwide declined by around 2.9% in the three days after Lehman.

Figure 2. Global banking sector


Note: 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.

Wholesale funding caused abnormal declines

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, within a country, the returns of banks with high wholesale dependence (87.1% or over of total liabilities in non-retail deposits) declined 1.6% more than those with low wholesale dependence (41.6% or less in non-retail deposits), as shown in the cumulative abnormal returns shown in Figure 3. This difference is significant and large. It corresponds to two-thirds of the average stock price decline of the banking sector (see Figure 2), implying that differences related to the use of wholesale funds are of the same order of magnitude as 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.

A similar but weaker pattern emerges during the early stages of the crisis (August 9, 2007), which confirms the presence of liquidity based transmission but suggests that other factors, such as the exposure of international banks to subprime mortgages, may have initially played a more important role. These findings are not driven by other potential sources of differential responses to the liquidity crunch related to individual banks’ riskiness, size, exposure to Lehman Brothers, ownership, or specialisation.

Figure 3. Banks with high and low wholesale dependence


Note: 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.

Country characteristics played a role

Further evidence shows that some country characteristics, such as the coverage of deposit insurance, the amount of international reserves, and the quality of financial regulation, can reduce the vulnerability of wholesale dependent banks to liquidity crunches, while other characteristics such as the degree of international financial and banking integration may amplify it. As an example, Figure 4 contrast the evolution of the cumulative abnormal returns of banks with high and low use of wholesale funds in a country with low banking sector integration (Panel A) and high banking sector integration (Panel B).

Figure 4. Banks with high and low wholesale dependence (controlling for vulnerability to a liquidity crunch)


Note: 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. Panel A (B) shows the result for banks in countries with low (high) fraction of external loans to total bank assets.

Consequences for the real economy

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. Between the end of 2007 and 2008, bank loans in the 44 countries I study declined by about 2%. But within the same country, loans in a bank with high wholesale dependence decline 0.7% 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).

Efficiency-vulnerability trade-off

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).

Some additional empirical results suggest that policies that ease the mobilisation of retail deposits or the provision of liquidity by the government, such as a good regulatory framework, a deposit insurance scheme, and an appropriate level of reserves, may reduce the importance of the sources of bank financing for the transmission of a liquidity crunch. But these policies may also reduce the average effect of a crunch on a country’s banking sector as a whole, so their dampening role has to be taken with caution.

The results also indicate that further thought is required on the relative safety of different sources of bank funds. While demand deposits have historically been considered risky and have 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).


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Perotti, Enrico and Javier Suarez (2009), “Liquidity Insurance for Systemic Crises”, Policy Insight 31, Centre for Economic Policy Research.

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The Economist (2008), “Lifelines”, 9 October.

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