Macroblog

The recent era of global trade expansion is over. Faced with increased geopolitical risk, fragile foreign supply chains, and uncertainties in the international trade environment, firms are postponing entry into foreign markets and pulling back from foreign activities (IMF 2023 ). Besides its direct effects on real activity, the recent rise in trade uncertainty has potentially important implications for the financial sector. This post describes how the lending activities of US banks were affected by the rise in trade uncertainty during the 2018–19 "trade war." In particular, banks that were more exposed to trade uncertainty contracted lending to all of their domestic nonfinancial business borrowers, regardless of whether these borrowers were facing high or low uncertainty themselves. Furthermore, banks' lending strategies exhibited the type of "wait-and-see" behavior usually found in corporate firms facing investment decisions under uncertainty, and the lending contraction was larger for those banks that were more financially constrained.

The 2018–19 trade war and banks' reaction to the rise in uncertainty
In a recent study, we examine how trade uncertainty affects banks' supply of credit to their nonfinancial business borrowers. We focus on the increase in trade uncertainty during the 2018–19 period, colloquially referred to as the trade war, which was marked by the renegotiation of trade agreements between the United States and other countries, as well as changes in tariffs, especially for products traded between the United States and China. As the chart below shows, trade uncertainty rose sharply at the beginning of 2018.

The Rise in Trade Uncertainty around US-China Trade Tensions

Source: "Trade Policy Uncertainty Index" from Caldara et al. (2020)
Notes: The chart shows the number of joint occurrences of "trade policy" and "uncertainty " in news articles of major global newspapers. The vertical line in 2018:Q1 marks the beginning of the "trade war" period of sustained high trade uncertainty and enactment of several waves of tariffs.

This episode did not go unnoticed by the banking sector . A survey of commercial loan officers (the Senior Loan Officer Opinion Survey, or SLOOS) conducted by the Federal Reserve in April 2019 included questions aimed at gauging the impact of trade uncertainty on banks' lending operations. Loan officers at about 70 banks were asked what mitigating actions the banks had taken in response to adverse developments in the international environment. The responses to these survey questions, tabulated in the chart below, suggest that the uncertainty prompted some banks to tighten lending standards and increase loan loss reserves. Some banks noted a perception that future loan losses might increase, with potential consequences for banks' ability to intermediate credit.

Bank actions to mitigate trade risks

Source: Federal Reserve Senior Loan Officer Opinion Survey (SLOOS), April 2019.

How might banks react to a rise in trade uncertainty? They may scale back their exposure to firms affected by uncertainty—as they typically do when some of their borrowers are hit by negative shocks—and provide additional lending to other, less affected, borrowers. Alternatively, they may become more cautious overall and, similarly to nonfinancial firms, postpone investing in new projects. In particular, banks may postpone new lending or tighten their terms—for instance, they may reduce approval rates on new loans, increase loan spreads, shorten loan maturities, or require more collateral on existing loans.

How did US banks exposed to trade uncertainty change their lending behavior during the trade war?
To estimate the impact of trade uncertainty on bank lending, we construct a novel measure of bank exposure to trade uncertainty by combining firm-level information on trade uncertainty with detailed data on US banks' loan exposures to domestic borrowers prior to the trade war (sourced from the US Y-14Q "credit register" data, which primarily contain data on large banks). The measure captures a bank's ex ante exposure to the realized rise in trade uncertainty during 2018–19. As the next chart shows, the trade war generated differences in trade uncertainty across sectors of the US economy, with several manufacturing and transportation-related sectors experiencing the largest increases in uncertainty. Therefore, banks with larger ex ante exposure to borrowers that operate in high trade uncertainty sectors had larger exposures to trade uncertainty in their overall loan portfolio.

Change in Sectoral Trade Uncertainty between 2016–17 and 2018–19

Source: Authors' calculations based on data from Hassan et al. (2019)
Notes: Nonfinancial sectors are listed in descending order of uncertainty. Values are calculated by averaging Hassan et al. (2019)'s firm-level trade uncertainty data, based on textual analysis of earnings call transcripts, across firms within three-digit NAICS sectors.

Combining the bank-level exposure to trade uncertainty with quarterly loan growth rates at the bank–firm level, we estimate panel regressions over 2016–19 and show that banks exposed to trade uncertainty contracted lending during the trade war period (2018–19) relative to the preceding period (2016–17). Banks more exposed to trade uncertainty also increased interest rates on new loans. Importantly, these results hold for all borrowers and for borrowers in sectors not as directly affected by trade uncertainty. Thus, banks exposed to trade uncertainty do not appear to differentiate across borrowers in their lending behavior. Instead, banks facing a rise in uncertainty adopt a wait-and-see approach by contracting credit for all borrowers.

The effect of trade uncertainty on bank lending that we identify is economically meaningful. A one standard deviation increase in bank exposure to trade uncertainty is associated with a 2.6 percentage point decline in loan growth at the bank-firm pair level (compared to 0 percent median loan growth for the sample) and an increase in interest rates of 6.5 basis points (compared to a 185 basis point median loan spread for the sample).

The mechanisms underlying banks' reactions to increased trade uncertainty are consistent with real-options theory, which predicts that firms postpone investment in the face of uncertainty. More-exposed banks reduce the maturity of loans and shift toward types of loans that can be called in early (so-called demandable loans). Moreover, given that they anticipate a wider dispersion in loan returns and may have difficulties forecasting revenues and capital needs, exposed banks downgrade the perceived creditworthiness of firms, as reflected in the higher probabilities of default that they assess for those firms. Exposed banks also contract their lending more strongly to firms that are perceived as likely to be adversely affected by the trade war and hence riskier ex ante—namely those firms in manufacturing sectors that receive low import protection and those firms in sectors with high import dependence.

Another explanation for banks' pullback from risk-taking amid higher uncertainty is a "financial constraints" channel that emphasizes the role of capital constraints faced by banks. Exposed banks with lower levels of capital should be less able to withstand loan losses, may experience an increase in funding costs, and should thus contract their lending by more than other banks. Indeed, banks with lower levels of regulatory capital at the time of the trade war or under adverse stress-test scenarios cut back the supply of loans—to all borrowers—more than other banks. Consistent with both mechanisms, exposed banks have lower tolerance for risk-taking as they rebalance portfolios away from commercial loans and into safer assets, notably securities.

What are the implications for economic activity?
The contraction in bank credit supply arising from trade uncertainty may impact activity in the real sector, especially for bank-dependent firms. We use lending relationships before the trade war to construct a measure of firms' exposure to trade uncertainty via their relationship with exposed banks. We then relate this measure to firms' future investment and leverage. More-exposed firms are found to be unable to substitute for reduced bank lending through alternative sources of finance and exhibit relatively lower total debt growth and investment rates. A one standard deviation increase in firms' exposure to trade uncertainty is associated with an economically meaningful decrease in the growth rate of the firms ' total debt and in their investment rate in 2018–19 by 2.4 and 2.7 percentage points, respectively. These results are consistent with credit supply contraction having a material adverse effect on exposed firms' real outcomes. Moreover, private firms—which are more likely to depend on bank financing—and firms with a higher share of bank debt experience relatively worse real outcomes.

Overall, our study confirms that banks are a conduit for amplifying the effects of trade uncertainty. This financial channel is contractionary for a broad spectrum of firms, not exclusively those in sectors directly exposed to the trade war.