The effect of US stress tests on monetary policy spillovers to emerging markets

• Author: Tim Schmidt‐Eisenlohr,Friederike Niepmann,Emily Liu
• Date: 01 February 2021
• Published date: 01 February 2021
• DOI: http://doi.org/10.1111/roie.12502

Rev. Int. Econ. 2021;29:165–194. wileyonlinelibrary.com/journal/roie

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165

© 2020 John Wiley & Sons Ltd

Received: 30 November 2019

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Revised: 15 July 2020

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Accepted: 4 September 2020

DOI: 10.1111/roie.12502

SPECIAL ISSUE PAPER

The effect of US stress tests on monetary policy

spillovers to emerging markets

FriederikeNiepmann

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TimSchmidt-Eisenlohr

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EmilyLiu

The views in this paper are solely the responsibility of the authors and should not necessarily be interpreted as reflecting the

views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve

System.

Division of International Finance, Board of

Governors of the Federal Reserve System,

Washington, DC, USA

Correspondence

Friederike Niepmann, Division of

International Finance, Board of

Governors of the Federal Reserve System,

Constitution Avenue NW, Washington, DC

20551, USA.

Email: Friederike.Niepmann@frb.gov

Abstract

This paper explores the transmission of US monetary policy

through US banks to emerging market economies (EMEs)

and the role that stress tests play in this transmission. Data

on US banks’ monthly commercial and industrial loan

originations shows that: (a) US bank lending to EMEs was

sensitive to domestic monetary policy changes during the

zero-lower bound period. (b) Effects of monetary easing

were heterogeneous across banks and depended on banks’

stress test results, a proxy for their capital strength. Only

banks that comfortably passed the stress tests issued more

loans to EME borrowers. (c) Effects of monetary tighten-

ing were more similar across banks. (d) Banks shifted their

lending to safer borrowers within EMEs in response to

monetary easing, leaving the risk of their overall loan books

unchanged. These results support the hypothesis that bank

capital affects the transmission of easier monetary policy,

including across borders. We conjecture that bank lending

to EMEs during the zero-lower bound period would have

been even higher had the United States not introduced stress

tests for their banks.

JEL CLASSIFICATION

E44; F31; G15; G21; G23

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NIEPMANN Et Al.

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INTRODUCTION

There has been much debate about whether and how US monetary policy, especially US quantitative

easing, transmits to other countries and whether macroprudential policies can help limit these interna-

tional spillovers.1 This paper contributes to this discussion, studying the role of US banks and stress

tests for the transmission of US monetary policy across borders. The US banking sector is one of the

largest providers of cross-border banking loans, with about 30% of the largest US banks’ new com-

mercial and industrial loans given to foreign borrowers.2 At the same time, stress tests represent the

only macro-prudential tool the United States employs, with the Comprehensive Capital Analysis and

Review (CCAR) sitting “right at the intersection of the micro-and macroprudential worlds” (Williams

et al., 2015).

To investigate monetary policy spillovers through US banks, we draw on bank lending data from

regulatory filings (Y-14 reports), which banks participating in US stress testing need to file on a quar-

terly basis. The data provide detailed information on individual commercial and industrial (C&I) loans

above $1 million that these banks issue. From these data, we construct the monthly volume of new

C&I loans by bank and counterparty. The sample runs from 2012 to 2017. Our preferred measure of

changes in US monetary policy is the monthly change in the Federal Funds rate, which is replaced by

the monthly change in the shadow rate from Wu and Xia (2016) during the zero-lower-bound period.

As alternative measures, we also employ the size of the Federal Reserve’s balance sheet to capture the

effects of unconventional monetary policy, as well as monthly US monetary policy shocks provided

by the International Banking Research Network and derived from a structural vector autoregression

(VAR), following Gertler and Karadi (2015).

In line with earlier work (e.g., Demirguc-Kunt et al., 2017; Lee et al., 2015; Morais et al., 2015;

Temesvary et al., 2018), we find that US banks increase their lending to emerging market borrowers

when US monetary policy eases. A 15-basis-point decrease in the Fed Fund rate/shadow rate (corre-

sponding to one standard deviation) increases loan issuance by 10%. Of note, the effects of monetary

policy changes on emerging market lending are only present during the zero-lower bound period,

while the relevant coefficients are not significant for the post-2015 period. The lack of significant

effects post-liftoff is somewhat surprising but is consistent with the idea of a reversal interest rate

close to the lower bound as proposed by Brunnermeier and Koby (2018). Effects on loan issuance to

advanced foreign economies are not significant.

For our main analysis on the role of stress tests, we complement our dataset with information from

the Federal Reserve’s CCAR. CCAR is an annual exercise that subjects the largest US Bank Holding

Companies (BHCs) to stress tests. Using supervisory models, supervisors project each bank’s capital

ratios under baseline, severe, and severely adverse scenarios. A bank fails the test when its Tier1 cap-

ital ratio falls below a minimum required threshold over the forecast horizon.3 In this case, the bank

is not able to go through with its original capital plans. Through its effects on banks’ ability to pay

out dividends or buy back shares, in addition to other costs that banks may incur when failing CCAR

(e.g., reputational costs), the stress tests impact bank lending and risk taking. Indeed, Acharya et al.

(2018) and Cortes et al. (2018) find that banks reduced their credit supply because of the stress tests.

We therefore conjecture that CCAR stress tests may affect the transmission of US monetary policy

across borders.4

In line with this conjecture, banks with lower minimum capital ratios in CCAR changed their lend-

ing to emerging market borrowers less than banks with better CCAR results in response to a change

in monetary policy. Differences across banks are quantitatively meaningful. While a bank with a 2.2%

CCAR buffer increases its loan issuance to emerging markets by 10%, a bank with a buffer of 30 basis

points hardly responds.