Summary:
In recent year, China's foreign exchange (FX) market has undergone a change: the current account surplus has narrowed, while the volatility of capital accounts has been intensifying. One consequence of this is that FX transactions between banks and customers and between the central bank and commercial banks affect the amount of currency and base money, respectively. We observe that the channels used by the central bank to input base money have also changed: the proportion of funds outstanding for FX transactions continues to decline, while the use of monetary policy tools to input base currency continues to rise. These structural changes will have an impact on banks' balance sheets, with far-reaching implications for bank loan behavior and the macro-economy. Thus, we explore whether the changes in FX transactions are related to banks' loan behavior. We start from the financial supply side by adopting a local equilibrium analysis framework and using a combination of theoretical and empirical analyses. We first construct a three-phase model based on bank balance sheets and introduce liquidity administration cost. The model includes two banks, one large and one small. When FX flows in, both banks obtain deposits and base money via FX transactions. The large bank is more competitive than the small bank in obtaining deposits, and thus liquidity is distributed between the two banks in an unbalanced way. In the interbank market, the two banks borrow from each other to achieve a balance sheet equilibrium. The structural distribution of deposits results in a difference in loan behaviors between the two banks. By theoretical deduction, we find that (1) the risk-taking level of banks increases with net FX inflow, and that large banks are more sensitive to FX changes than small banks; (2) the greater the uncertainty caused by liquidity shocks, the weaker the relationship between risk-taking level and FX transactions; and (3) the more unbalanced the distribution of deposits, the greater the difference in the risk-taking level between the two banks. Based on the above theoretical analysis, we conduct empirical tests using data on FX transaction reports from SAFE and the quarterly financial data of 10 banks, and macroeconomic data from 2011 to 2018. We select the proportion of risk-weighted assets and conditional value at risk (CoVaR) as dependent variables. To alleviate the endogeneity problems of FX transactions and bank risk-taking levels, we (1) qualitatively analyze the correlations between FX loans and FX transactions, to exclude the pro-cyclical effect of bank loan behavior and FX transactions; (2) introduce liabilities to the central bank as an instrumental variable for FX transactions; and (3) use CoVaR and ΔCoVaR as dependent variables in robustness testing. The results verify our theoretical deductions and show good robustness. We draw the following conclusions and policy suggestions. (1) There is a significant correlation between FX transactions and the risk-taking level of banks. Therefore, it is recommended that relevant departments take timely measures to hedge the FX inflow gap caused by sluggish trade and thereby prevent the pro-cyclical loan behavior of banks from causing a severe contraction of social credit and aggravating economic fluctuations. (2) The structure of the deposit market plays a key role in encouraging banks to improve their risk-taking level, and too concentrated a deposit share will hinder the optimal allocation of loan resources. To effectively incentivize large banks to provide high-quality financial services for SMEs, the concentration of deposits in the market should be somewhat limited, and more liquidity support should be given to banks that actively serve the real economy than to those that do not. (3) Liquidity expectations have a significant impact on bank loan behavior. As the world is undergoing increasing umcertainty, FX transactions fluctuate more significantly; thus, multiple policy tools must be employed to ensure that adequate levels of liquidity are maintained and that to support the management of bank liquidity expectations. We make the following contributions. First, we incorporate international financial factors into the study of banks' loan behavior, which represents an innovation in financial intermediary theory. Second, we establish the theoretical model that examines how FX transactions affect the risk-taking level of banks through money creation at the micro-level, and further explore the mechanism by which FX affects bank credit. Third, we use the data from FX transaction reports to conduct empirical study on the relationship between FX and the risk-taking level of banks.
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