Le Pont de Londres: monetary policy spillovers, prudential policies and the financial centre effect

Robert Hills, Simon Lloyd, Rhiannon Sowerbutts, Dennis Reinhardt, Matthieu Bussière, Baptiste Meunier and Justine Pedrono

Large amounts of capital flow across borders. But these can be destabilising. So can recipient countries employ prudential policies to offset monetary policy changes in centre countries? And does it matter where sending banks are located? Our findings suggest it does. Our case study of French banks operating in London – part of a broader international initiative – suggests prudential policies have a much bigger offsetting effect on French banks’ lending out of the UK’s financial centre than on their lending out of headquarters in France. In line with those observations, we uncover evidence of a ‘London Bridge’ in cross-border lending: the way French banks channel funds to the UK is responsive to prudential policies in the rest of the world.

A rich literature studying the high degree of co-movement in capital flows, asset prices and credit growth in the world economy – the ‘global financial cycle’ – identifies centre-country monetary policy as an important driver of this financial cycle. And the integration of global financial markets and banking systems mean that the capital in/outflows from monetary policy spillovers can be sizable leading to destabilising effects for recipient countries. Many people (most notably Hélène Rey’s 2013 Jackson Hole paper) have advocated taking macroprudential policies to offset this destabilising effect.    

International financial centres, such as the UK, are used to obtain, channel and optimise funding of large international banking groups, implying that a large share of those cross-border capital flows are likely to transit through them.

By combining analysis from two confidential data sets in a recent working paper – we have one team at the Bank of England and another at the Banque de France – we examine how monetary policy shocks and prudential policies interact to influence cross-border lending of French banks from France vs French banks’ affiliates (ie branches and subsidiaries) in the UK. Because we have the same set of banks in the UK and French data – French-headquartered Global Systemically Important Banks (G-SIBSs) – we can really isolate the location effect of lending from the headquarters vs the financial centre. Lending from the headquarter may be more relationship-based and longer-term than lending via a financial centre making it, in turn, less responsive to prudential policies in receiving countries which often react to swings in the global financial cycle.

Finally, we are able to examine whether there is a ‘London Bridge’ in cross-border lending by investigating whether the funds French G-SIBs channel to the UK are responsive to global prudential policy.

The French vs UK banking systems

There are important differences between the French and UK banking systems, particularly when it comes to cross-border lending. First, both the mean and standard deviation of cross-border lending growth from the UK is larger than from France. Mean lending growth from France is around 2%, a fifth of the mean lending growth of French banks from the UK, hinting at the important role for international financial centres in channelling funds. The standard deviation of lending growth from the UK is over 50% larger than from France too, suggesting that cross-border lending from the UK may indeed be more responsive to shocks and prevailing policy settings. Second, although some headline bank balance sheet characteristics of French banks in France vs the UK are similar (eg total assets, capital ratio), there is a marked difference in these banks’ international share. In France, the average international share of a G-SIB is just 19%, compared to 70% for French-owned banks in the UK, suggesting that cross-border lending from financial centres like London may have a different flavour to the cross-border lending from bank headquarters.

Interactions between monetary and prudential policies

We run regressions to examine the effect of monetary policy surprises – the difference between actual and expected monetary policy – on cross-border lending, while controlling for more fundamental factors which could drive lending such as GDP growth. Using surprises helps us to overcome the potential endogeneity issue in that monetary policy may depend on bank lending, or both could be driven by omitted factors that we do not control for. We also run regressions which examine cross-border lending, but also interact these monetary policy surprises with prudential policies the receiving country has taken in the past to investigate how prudential policies may offset these capital inflows. 

We find that French G-SIBSs’ lending from the UK, in response to surprise changes in EA monetary policy, are more sensitive to recipient-country prudential policy than French G-SIBs’ lending from France. Or, put another way: foreign prudential policies have a bigger offsetting effect on capital inflows in response to a surprise EA monetary policy loosening when the lending is coming from the UK than when the lending comes from France. When we examine other EA-headquartered banks’ lending from the UK, we find a similar pattern, suggesting that this is not just a special French result.

We think this is due to the different types of lending being done from London vs France: our paper indicates that lending from an international financial centre is more responsive to prudential policy factors, possibly due to economies of scope with other financial transactions being undertaken in a financial centre or lending being less based on longer-term relationships compared to lending from the headquarter. 

Indeed, we find evidence of a ‘London Bridge’ in cross-border lending. In response to a EA monetary policy loosening, the cross-border lending of large French G-SIBs from their French headquarters to the UK increases significantly, an effect that is dampened by the overall setting of prudential policy in the rest of the world (ie in all countries excluding France and the UK). From there, UK affiliates of French G-SIBs engage in cross-border lending with the rest of the world in a manner that is sensitive to the prudential policy setting in final-destination countries. Taken together these findings suggest that large French banks seek to channel funds via London, an international financial centre, to engage in different types of cross-border lending to those carried out from their French headquarters.

What does this mean for policy?

We show that, not only are prudential policies effective in offsetting capital inflows as a response to monetary policy surprises, but they are particularly effective in offsetting capital flows through financial centres, where lending is more likely to be driven by the financial cycle.

It also speaks to more co-operation among supervisors at an international level: banks may be behaving very differently at home vs abroad.

Robert Hills works in the Bank’s Monetary and Financial Conditions Division, Simon Lloyd and Dennis Reinhardt work in the Bank’s Global Analysis Division, Rhiannon Sowerbutts works in the Bank’s Macroprudential Strategy and Support Division, Matthieu Bussière and Baptiste Meunier work at the Banque de France and Justine Pedrono works at Autorité de Contrôle Prudentiel et de Régulation (ACPR), Banque de France.

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