Transmission of a global financial crisis shock to an emerging economy

• Date: 01 April 2019
• DOI: http://doi.org/10.1002/ijfe.1689
• Author: Syed Mujahid Hussain,Asim Rehman,Sajid M. Chaudhry
• Published date: 01 April 2019

RESEARCH ARTICLE

Transmission of a global financial crisis shock to an

emerging economy

Asim Rehman

1

| Sajid M. Chaudhry

2

| Syed Mujahid Hussain

3

1

Nust Business School, National

University of Sciences and Technology,

Islamabad, Pakistan

2

Economics, Finance and

Entrepreneurship Group, Aston Business

School, Aston University, Birmingham

B4 7ET, UK

3

Department of Economics and Finance,

College of Economics and Political

Science, Sultan Qaboos University,

Muscat, Oman

Correspondence

Sajid M. Chaudhry, Economics, Finance

and Entrepreneurship Group, Aston

Business School, Aston University,

Birmingham B4 7ET, UK.

Email: s.m.chaudhry@outlook.com

JEL Classification: G01; G21; D82

Abstract

Using a unique dataset consisting of all corporate loans in Pakistan, we study

the impact of the global financial crisis (GFC) on the lending ability of its bank-

ing sector. We also take into account various bank and loan types along with

extensive margins, firm size effects, and impact of information asymmetry.

Our findings show that the Pakistani banking sector was indeed affected by

the GFC as high exposure banks, who borrow relatively more internationally,

reduce lending to local firms and this impact is larger for small firms. We also

find differences in the lending ability of various bank types and loan types. By

using direct information asymmetry measure, we find that banks reduced

lending after the global financial crisis shock. However, the information

gathered from the previous relationship of the borrower with relatively low

exposure banks can overcome the negative financial shock and increase

lending after the shock. These findings are very relevant in the context of the

spillover effects of the GFC and have important policy implications for emerg-

ing markets.

KEYWORDS

banks, financial contagion, financial crisis, information asymmetry

1|INTRODUCTION

Banks around the world are interconnected because they

provide lending and other financial services, not only to

domestic financial and nonfinancial firms but also to cus-

tomers abroad. On one hand, this interconnection provides

liquidity support and reduces the idiosyncratic risk of

individual banks via diversification, whereas on the other

hand, it also leaves banks vulnerable to systemic shock in

the form of a speculative attack, financial panic, or herd

behaviour (Kleimeier, Lehnert, & Verschoor, 2008). An

important question is whether, and to what extent, this

systemic shock is transmitted to the real economy.

1

In this

regard, the impact of the last global financial crisis (GFC)

of 2007–2009 on real businesseshas also attracted consider-

able attention (see Berg & Kirschenmann, 2015; De Haas &

Van Horen, 2013; Giannetti & Laeven, 2012; Ivashina &

Scharfstein, 2010; Schnabl, 2012). However, the impact

of the GFC on emerging markets has been the subject

of relatively few studies, probably due to the limited

availability of data.

2

As we had access to the relevant data, we study the

impact of the GFC on an emerging market. In doing so,

we analyse the changes in credit availability to firms in

Pakistan as a result of the exogenous economic shock,

measured as borrowing outside Pakistan by Pakistani

banks.

3

Because the banks and financial intermediaries

in developed countries were directly and most severely

affected during the GFC, we examine whether transmis-

sion of capital flows from international banks to local

banks in an emerging economy was also affected by the

liquidity constraints faced by the international banks

Received: 14 March 2017 Revised: 16 August 2018 Accepted: 10 September 2018

DOI: 10.1002/ijfe.1689

740 © 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2019;24:740–760.wileyonlinelibrary.com/journal/ijfe

(Cetorelli & Goldberg, 2012; Khwaja & Mian, 2008). Paki-

stan had close trading relationship with the countries

from where the GFC originated. Based on 2006 data,

United States was the biggest trading partner of Pakistan.

Moreover, six European countries were also among the

top 10 trading partners of Pakistan.

4

We reckon that the

countries with significant trading relationship with Paki-

stan were also closely linked to the Pakistani banking sec-

tor. Therefore, the main objective of this paper is to study

whether the financial shock that originated in those

countries impacted the Pakistani economy during the

GFC through the credit channel. To that end, we use a

unique dataset obtained from the Credit Information

Bureau (CIB) of the State Bank of Pakistan, comprising

all business loans made to firms by commercial banks

in Pakistan, to estimate the transmission of the economic

shock via spillover from banks to real firms.

In order to establish the adverse effects of interna-

tional shocks through the banking system, the Pakistani

banking sector provides an ideal setting to study the

transmission of international financial shocks, as local

banks differ greatly in their international exposure. The

international exposure of these banks ranges from zero

to 22.3%. We measure this international exposure by the

borrowing of Pakistani banks outside Pakistan from other

financial institutions and hypothesize that the higher the

borrowing outside Pakistan, the higher the financial

shock to banks, and hence, those banks transmit the

shock to the real economy in Pakistan. Our primary var-

iables of interest are high, intermediate, and low exposure

banks, classified as follows. Banks that have over 8% of

their total borrowing outside Pakistan are considered as

high exposure ones, whereas those with between 4%

and 8% borrowing outside Pakistan are classified as inter-

mediate exposure banks, and those with less than 4% bor-

rowing outside Pakistan as low exposure banks.

5

The

higher the exposure of the banks, the more they are

expected to transmit the financial shock to the local mar-

ket.

6

This classification is similar to that of Schnabl

(2012), who classifies banks into these categories and

then measures the impact of lending changes by each

type of bank on firms in Peru. The uniqueness of our

dataset lies in the fact that it covers the period of the

GFC perfectly, that is, from April 2006 to March 2011. It

contains all the business loans that were outstanding at

the month‐end with each bank, which allows us to

address the identification challenge arising from the eco-

nomic events that triggered the financial shocks. These

shocks may also affect credit demand.

Our findings show that the banking sector in Pakistan

was indeed affected by the GFC, as the lending ability of

various banks was negatively affected (i.e., the intensive

margin), similar to the findings of Forbes (2001), Forbes

and Chinn (2004), Khwaja and Mian (2008), Schnabl

(2012), and Cetorelli and Goldberg (2012). Our empirical

results also indicate that there was transmission of finan-

cial shock from international markets to Pakistan. This

finding is interesting because Ali (2009) notes that Paki-

stan has been relatively well insulated against contagion

coming from international financial markets.

7

Our

results, however, confirm that lending by Pakistani banks

to local firms was reduced. This reduction in lending was

reported by the high exposure banks, whereas there was

increase in lending by the low/relatively low

8

exposure

banks. We also find that “foreign”banks

9

transmit the

global financial crisis shock and reduce their lending.

The findings on the exit from the market of old firms

and the extension of credit to new firms (i.e., the exten-

sive margin) indicate that the firms that borrowed from

relatively low exposure banks are less likely to exit and

are more likely to have survived after the crisis. However,

lending to small firms was reduced, irrespective of

whether they borrowed from relatively low or high expo-

sure banks. The findings regarding different types of

banks reveal that private and big banks reduce their lend-

ing; however, contrary to Farooq and Zaheer (2015), we

do not find any statistically significant evidence that the

granting of Islamic loans increased after the financial

shock. We find that high exposure banks reduced their

agricultural loans after the financial shock in contrast

with Berg and Kirschenmann (2015). However, relatively

low exposure banks increased their lending in that

regard. This is intuitive, because the relatively low expo-

sure banks are mostly domestic, small banks, which

mainly focus on agriculture financing. Our findings on

information asymmetry show that bank reputation as a

proxy for information asymmetry, as well as the previous

interaction of the borrower with the bank, was not able to

overcome the information asymmetry problems and

banks still reduced lending after a financial shock. How-

ever, highly reputed banks with relatively low exposure

were able to overcome the information asymmetry prob-

lems and increased their lending after the GFC.

Our paper adds to the existing literature in the follow-

ing ways. First, it complements the rare literature on the

transmission of the global financial crisis from developed

countries to banks and firms in an emerging economy.

Second, we provide a detailed analysis of different bank

types (e.g., private and privatized banks

10

) and different

types of loans (e.g., Islamic, export, and agriculture loans)

provided by local banks. By doing this, we are better able

to analyse the impact of the global financial crisis on the

real economy in Pakistan. Third, our analysis also sheds

light on information asymmetry and its impact on lend-

ing changes after the recent financial crisis using loan

level data. Lastly, our dataset perfectly covers the relevant

REHMAN ET AL.741