Using data on the external assets and liabilities of global banks based in the UK, the world's largest centre for international banking, we identify exogenous cross-border banking flows by constructing novel Granular Instrumental Variables. In line with the predictions of a new granular international banking model, we show empirically that cross-border flows have a significant causal impact on exchange rates. A 1% increase in UK-based global banks’ net external US dollar-debt position appreciates the dollar by 2% against sterling. While we estimate that the supply of dollars from abroad is price-elastic, our results suggest that UK-resident global banks' demand for dollars is price-inelastic. Furthermore, we show that the causal effect of banking flows on exchange rates is state dependent, with effects twice as large when banks’ capital ratios are one standard deviation below average. Our findings showcase the importance of banks' risk-bearing capacity for exchange-rate dynamics and, therefore, for insulating their domestic economies from global financial shocks.
We build a novel two-country macro-banking model to quantitatively explore various aspects of cross-country financial contagion and macroprudential regulation. Our model features cross-border bank lending, endogenous bank default, and shocks to the volatility of domestic and foreign bank asset returns (`bank risk shocks'). Our results show that increased distress in the banking sector of the lender country leads to a global recession, characterised by synchronised financial cycles. Conversely, increased bank distress in the borrower country generates a domestic recession and asymmetric financial cycles. Moreover, we demonstrate that bank capital regulation plays an important role in the international transmission of shocks originating in the banking sector. Stricter capital requirements in the lender country enhance the resilience of its banks to banking shocks, thereby mitigating the adverse spillovers to the borrowing country. In contrast, stricter capital requirements in the borrowing country dampen the negative domestic effects of banking shocks without, however, having sizeable effects on the lender country.
Labour Adjustments, Liquidity Constraints and Optimal Short-Time Work Subsidies
I characterise efficiency and optimal policy in a tractable equilibrium model with labour and financial market imperfections. The model features (i) firm heterogeneity, (ii) occasionally binding cash-flow constraints, (iii) labour search-and-matching, and (iv) both intensive (work hours) and extensive (job creation and destruction) margins of adjustment. I prove that binding liquidity constraints lead to inefficiently high equilibrium unemployment and underutilisation of the intensive margin. However, I also show that short-time work (STW) policies can be used to implement the constrained efficient allocation. Finally, I present closed-form solutions for the optimal time-varying STW subsidy and eligibility criterion.