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Finland

Author(s):
International Monetary Fund
Published Date:
August 2012
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I. Analytical Note 1: International Spillovers1

This note sheds light on potential spillovers to Finland from various shocks associated with cross-country interlinkages. First, the note provides an overview of the trade and financial linkages. Second, the note assesses the impact of global fiscal consolidation on Finland via trade links. Third, it quantifies dynamic contributions from external sources to growth and uses these contributions to forecast the potential loss to Finnish GDP from a growth slowdown in other European countries. Fourth, the note analyzes the potential impact from banking sector or sovereign stress.

A. Trade and Financial Linkages

1. Finland’s regional trade pattern is relatively diversified. With an export to GDP ratio of around 39 percent in 2011, Finland is a typical small open economy in Northern Europe. However, the regional diversification of trade is rather atypical. Germany, Sweden, and Russia account for roughly similar shares of Finnish merchandise exports, while imports from Russia (18 percent in 2011) account for a larger share than imports from Sweden and Germany (14.1 and 13.9 percent). Other significant import trading partners include the Netherlands, the U.S., and China. Developing countries and emerging markets account for a comparably high share of exports, recently strengthened further by high export growth to Asia. Finland’s trade balance is supported by a surplus with Asia and the U.S., while Finland runs significant deficits with other euro area members and Russia due to imports of consumer goods and raw materials, respectively.

Comparison - Export Market Destinations

(in percent of total merchandise exports)

Sources: IMF Direction of Trade Statistics and Fund staff calculations.

Finnish Trade by Regions and Countries, 2011
Origin/DestinationBalanceExportsImports
Value in

USD mill.
Value in

USD mill.
Share

(percent)
Change

(percent)
Value in

USD mill.
Share

(percent)
Change

(percent)
Total−6,25176,723100.01382,974100.022
EU−8,05343,53656.71551,58962.217
Sweden−2,4239,27412.11711,69614.118
Germany−3,7387,82910.21211,56713.916
Netherlands−1,1505,2986.9206,4487.815
United Kingdom1,4624,0465.3252,5843.119
France−602,4443.242,5043.01
Italy−2121,8772.452,0892.515
Poland6142,2012.9231,5871.932
Spain4241,3741.8−29491.120
Estonia−4841,7442.3172,2282.726
Denmark−8951,6132.1212,5083.019
Norway−2542,1552.8202,4102.986
Russian Federation−7,6727,2599.52514,93118.026
America2301,9902.6201,7602.131
United States1,9073,8795.1−191,9722.442
Developing Asia4855,6177.365,1316.222
China,P.R.: Mainland883,6604.843,5724.318
Sources: IMF Direction of Trade Statistics and Fund staff calculations.
Sources: IMF Direction of Trade Statistics and Fund staff calculations.

2. The banking sector has significant linkages with banks in Sweden and Denmark. Although claims of Finnish banks on foreign banks have increased compared to pre-crisis levels, they declined to slightly below 9 percent at end-Q4 2011. However, these figures understate the strong regional financial linkages, which are due to the domination of the domestic banking sector by subsidiaries of large international banks from Sweden and Denmark. When using assets of banks that reside in Finland as a measure of inter-linkages, claims on banks outside Finland reached 165 percent of GDP in 2011Q4. The more than tripling of exposure—from 49 percent of GDP in 2010Q1—is a consequence of Nordea Group’s decision to concentrate its derivatives business on the balance sheet of Nordea Bank Finland. While this has left the net position relatively unchanged, it has increased the bilateral exposure. These linkages are also reflected in the high foreign liabilities of Finnish banks to the Swedish banking sector.

Finland: Foreign Claims of Finnish Banks, 2005–11

(Percent of GDP)

Sources: BIS, Haver Analytics, and Fund staff calculations.

Finland: External Position of Banks in Finland, 1984–2011

(Percent of annual GDP)

Sources: BIS (Table 2A), Haver Analytics, and Fund staff calculations.

3. Though Finnish banks do not appear directly exposed to peripheral sovereign debt, exposures to select other counterparties are not negligible. International assets of Finnish banks on individual countries do not exceed 2 percent of GDP in the respective countries at end-2011. However, Finnish banks are indirectly exposed through international lending operations of banks active in Finland.2 For instance, on the basis of BIS end-2011 data, Swedish banks—of which several are active in Finland—hold claims abroad worth 169.4 percent of Swedish GDP, of which close to 20 percent of GDP are claims on Finland. The high liabilities of the Finnish banks to Swedish banks create upstream risk, as measured by a country’s potential rollover needs through both direct cross-border lending by banks and the domestic lending operations by foreign affiliates that are funded by their parent bank.3 The high international exposures of Swedish banks make this upstream risk not only subject to developments in Sweden (and Denmark, the home country of Danske Group, which has a subsidiary in Finland, Sampo Pankki) but also to developments in other countries on which Sweden has claims.

Finnish Bank Claims Abroad(As of end-December 2011)
USD billionShare (percent)
All countries23100.0
Developed countries2188.8
Europe2085.3
France314.4
Sweden314.2
United Kingdom210.1
Germany210.4
Netherlands29.6
Spain15.1
Norway15.4
Denmark13.8
Italy12.3
Ireland12.2
Other developed countries13.6
Australia00.9
United States01.8
Developing countries13.0
Offshore centres00.3
Sources: BIS (on ultimate risk basis) and Fund staff calculations.
Sources: BIS (on ultimate risk basis) and Fund staff calculations.
Swedish Bank Claims Abroad(As of end-December 2011)
USD billionShare (percent)
All countries846100
Developed countries75789
Europe65277
Denmark19123
Norway13216
Finland16319
Germany678
United Kingdom405
Estonia172
France101
Netherlands101
Spain30
Greece, Ireland, Portugal20
Italy10
Other developed countries10512
United States10112
Developing countries658
Latvia, Lithuania, Estonia465
Poland111
Offshore centres233
Source: BIS, on ultimate risk basis.
Source: BIS, on ultimate risk basis.

4. Foreign direct investment (FDI) in Finland is dominated by Sweden. On the basis of 2010 bilateral FDI data, Swedish residents account for 55.9 percent of the FDI stock in Finland, and the Nordic countries combined contribute 63.7 percent of the total FDI stock. These are followed by the Netherlands (15.8 percent of the total FDI stock) and Germany (6.4 percent of the total FDI stock). Similarly, of total outward Finnish FDI, stocks are largest in Sweden (25.9 percent of total outward FDI stock), but outward shares are also significant for Belgium (21.1 percent), the Netherlands (16.5 percent), Luxembourg (14.6 percent), the U.S. (7.8 percent), and Germany (4.5 percent).

B. Fiscal Spillovers

5. Export diversification and limited exposure to countries with high fiscal consolidation needs imply that worldwide fiscal consolidation may only have small spillovers on Finland. Two of Finland’s main trading partners—Sweden and Germany—are projected to tighten their fiscal balances by less than the average in the euro area. This should dampen the impact of external fiscal tightening on Finnish GDP growth in 2012–13 despite the relative openness of the Finnish economy.

6. However, GDP growth could slow owing to domestic projected fiscal consolidation. We simulate the effect of Finnish and external fiscal consolidation on Finnish output growth for 2011–13, allowing for carry-over effects from fiscal adjustment in the previous period to current GDP growth, using a model based on the national accounting framework.4 Estimates are based on changes in cyclically adjusted revenue and expenditures of 20 countries, which cover about 70 percent of world GDP and more than 80 percent of Finnish exports.

Foreign Direct Investment Positions, 2010(Billions of euros)
InwardOutwardNet
World74.7128.2−53.5
European Union70.798.9−28.1
United Kingdom1.11.4−0.3
Nordics47.635.312.3
Sweden41.733.28.5
Denmark5.30.94.4
Norway0.51.2−0.6
EU-1723.760.0−36.3
Netherlands11.821.1−9.3
Belgium 1/−0.927.0−27.9
Luxembourg4.118.7−14.6
Germany4.85.8−1.0
France1.51.40.1
United States0.610.0−9.4
Canada0.12.0−1.9
Japan0.20.00.2
Sources: IMF Coordinated Direct Investment Survey and Fund staff calculations.

Direct investment positions are negative when a direct investor’s claims on its direct investment enterprise are less than the direct investment enterprise’s claims on its direct investor. Direct investment positions also can be negative due to negative retained earnings (which may result from the accumulation of negative reinvested earnings).

Sources: IMF Coordinated Direct Investment Survey and Fund staff calculations.

Direct investment positions are negative when a direct investor’s claims on its direct investment enterprise are less than the direct investment enterprise’s claims on its direct investor. Direct investment positions also can be negative due to negative retained earnings (which may result from the accumulation of negative reinvested earnings).

Fiscal Contribution to Growth 1/(Percentage points)
201120122013
Total growth impactOf which:Total growth impactOf which:Total growth impactOf which:
domestic effectspillover effectdomestic effectspillover effectdomestic effectspillover effect
Finland0.00.1−0.1−0.3−0.2−0.1−0.2−0.1−0.1
of which:
− current year−0.4−0.3−0.10.00.00.0−0.10.0−0.1
− carry over from previous year0.40.40.0−0.3−0.2−0.1−0.10.00.0
PPP weighted average−0.4−0.3−0.1−0.5−0.4−0.1−0.5−0.4−0.1
Simple average−0.6−0.5−0.1−0.7−0.6−0.2−0.7−0.5−0.1
Sources: Direction of Trade Statistics, World Economic Outlook, and Fund staff calculations.

Financial sector support recorded above-the-line was excluded for the calculation of the growth impact for Ireland (2.5 percent of GDP in 2009 and 5.3 percent of GDP in 2010) and the U.S. (2.5 percent of GDP in 2009, 0.4 percent of GDP in 2010, and 0.1 percent of GDP in 2011 and 2012). Financial sector support is not expected to have a significant impact on demand. For Russia, only non-oil revenues are assumed to have an impact on growth. Values may not add up exactly because of rounding.

Sources: Direction of Trade Statistics, World Economic Outlook, and Fund staff calculations.

Financial sector support recorded above-the-line was excluded for the calculation of the growth impact for Ireland (2.5 percent of GDP in 2009 and 5.3 percent of GDP in 2010) and the U.S. (2.5 percent of GDP in 2009, 0.4 percent of GDP in 2010, and 0.1 percent of GDP in 2011 and 2012). Financial sector support is not expected to have a significant impact on demand. For Russia, only non-oil revenues are assumed to have an impact on growth. Values may not add up exactly because of rounding.

7. Specifically, growth could be lowered by about 0.3 percentage point in 2012 on account of fiscal consolidation. The simulation results indicate that the domestic effect of fiscal consolidation is the main determinant of the growth slowdown from total fiscal consolidation. The largest effect should materialize in 2012 due to the cumulating effects from the carry-over from fiscal tightening in 2011 and 2012. Under the current budget plans there will be a smaller drag on GDP growth from fiscal consolidation in 2013.

Contribution to Growth from Global Fiscal Consolidation, 2011–13

(Percentage points)

Sources: Direction of Trade Statistics, World Economic Outlook and Fund staff calculations.

8. Negative growth spillovers from external fiscal consolidation are likely to be modest. The negative growth effect from external fiscal consolidation is estimated to be limited to less than ¼ percentage point in each year during 2011–13. In 2012, about 50 percent of the spillover is accounted for by Germany, France, and the Netherlands. The magnitude of the total spillover effect for Finland is in line with the average spillover in our sample. On the one hand, this is a result of the relatively high openness of the Finnish economy, which, on the other hand, is moderated by the prevailing direction of Finnish exports to countries with comparatively milder fiscal consolidation efforts.

C. Growth Spillovers

9. A multi-country VAR analysis is used to assess the risk to Finnish GDP growth from a decline in domestic demand in other European countries. Domestic components are identified following the VAR approach described in Poirson and Weber (2011), which allows decomposing the growth rate into long-run, dynamic domestic, and dynamic foreign components. After decomposing growth into these three components, three different shock scenarios are analyzed to assess the growth implications for Finland. The assumption underlying the first scenario is a ½ standard deviation reduction in the dynamic domestic growth component of Italy, Spain, Greece, Ireland, and Portugal for each quarter in 2012 compared to the implied values under the WEO projections. In the second scenario, only Sweden’s dynamic domestic growth component is lowered by ½ standard deviation. In the third scenario, all euro area members’ dynamic domestic growth component is lowered by ½ standard deviation. In each scenario, the new growth rates for all 17 countries in the sample are computed, holding all other domestic components unchanged.5

10. Foreign factors matter more for variation in Finnish growth than domestic factors. The dynamic domestic component to growth remained resilient throughout much of the crisis and supported the recovery. Most of the decline in output and its subsequent recovery of output were therefore driven by foreign factors. However, in the forecast period, the dynamic domestic component will exert a drag on GDP growth in line with the fiscal consolidation under way and a cooling down of consumer demand. It is important to note that the domestic component matters more for overall growth in Finland compared to some other small and medium-sized euro area members (e.g. Austria, Belgium, and the Netherlands). Swedish growth is even more dominated by domestic factors, despite a slightly higher export to GDP ratio. The exchange rate regime is likely to explain part of the difference as Sweden’s floating exchange rate helps mitigate the effect of external shocks on the domestic economy.

Finland: Growth Contributions, 2005–15

(Percentage points)

Sources: OECD, Poirson and Weber (2011), World Economic Outlook, and Fund staff calculations.

Sweden: Growth Contributions, 2005–15

(Percentage points)

Sources: OECD, Poirson and Weber (2011), World Economic Outlook, and Fund staff calculations.

11. A shock to domestic demand in the high spread countries in 2012,6 would impact moderately Finnish GDP growth. The shock would only moderately impact Finnish growth as growth would be largely unaffected in 2012 and lowered by about 0.3 percentage points in 2013. The response is stronger in the Netherlands and Germany. The milder response in Finland is mostly accounted for by the fact that Sweden does not appear to be negatively affected by the growth shock in the high spread countries and thus supports growth in Finland.

Output Growth Comparison: WEO Baseline

(Percent)

Sources: OECD, Poirson and Weber (2011), World Economic Outlook, and Fund staff calculations.

Output Growth Comparison: High Spread 2012 Shock

(Percent)

Sources: OECD, Poirson and Weber (2011), World Economic Outlook, and Fund staff calculations.

Output Growth Comparison: Sweden 2012 Shock

(Percent)

Sources: OECD, Poirson and Weber (2011), World Economic Outlook, and Fund staff calculations.

Output Growth Comparison: Euro Area Wide 2012 Shock

(Percent)

Sources: OECD, Poirson and Weber (2011), World Economic Outlook, and Fund staff calculations.

12. Conversely, shocks to all euro area members or to Sweden have somewhat larger consequences for Finnish growth. A shock to all euro area members (excluding Finland) could lower Finnish GDP growth by more than ½ percentage point in 2013. A ½ standard deviation shock in Sweden alone, which results in lower average 2013 Swedish growth of about 1 percentage point relative to the baseline, also has a negative effect. A growth reduction in Sweden lowers output growth in Finland by about 0.1 percentage point in 2012 and above ½ percentage point in 2013. This sensitivity to developments in one single country is underpinned by the multifaceted linkages that Finland has with Sweden.

D. Banking and Sovereign Stress Spillovers

13. Limited banking sector exposure to the euro area periphery countries implies very mild losses from even substantial haircuts in the sovereign debt of Greece or all the three IMF/EU-program countries. Building on the RES/MFU Bank Contagion Module, a spillover analysis is conducted to simulate the direct effects of losses on Finnish bank claims abroad.7 The direct exposure of the Finnish banking sector to the sovereign debt of Greece, Ireland, and Portugal is so low that there is no notable loss to Finnish banks even if they have to stand a simultaneous 50 percent default on sovereign assets held on the three program countries. In particular, such a default would not have any measured impact on the ability of Finnish banks to extend credit to the economy. Nonetheless, the analysis is performed at the aggregate level and therefore could hide potential larger losses for individual banks. Similarly, deleveraging needs are computed based on the Tier 1 capital ratio of the aggregate banking sector and thus could mask potential deleveraging needs of individual banks.

Spillovers to Finland from International Banks’ Sovereign Exposures(As of September 2011)
Shock originating fromMagnitude 1/Deleveraging

need 2/
Finnish banks’

losses (percent

of GDP)
Impact on credit

availability (percent

of GDP) 3/
Greece500.00.0−0.1
Greece, Ireland and Portugal500.00.0−0.2
Sources: RES/MFU Bank Contagion Module based on BIS, ECB, and IFS data.

Magnitude denotes the percent of sovereign on-balance sheet claims that default.

Deleveraging need is the amount (in percent of Tier I capital) that needs to be raised through asset sales in response to the shock in order to meet a domestic banking sector Tier I capital asset ratio of 10 percent, expressed in percent of total assets and assuming no recapitalizations.

Reduction in foreign banks’ credit to Finland due to the impact of the analyzed shock on their balance sheets, assuming a uniform deleveraging across domestic and external claims.

Sources: RES/MFU Bank Contagion Module based on BIS, ECB, and IFS data.

Magnitude denotes the percent of sovereign on-balance sheet claims that default.

Deleveraging need is the amount (in percent of Tier I capital) that needs to be raised through asset sales in response to the shock in order to meet a domestic banking sector Tier I capital asset ratio of 10 percent, expressed in percent of total assets and assuming no recapitalizations.

Reduction in foreign banks’ credit to Finland due to the impact of the analyzed shock on their balance sheets, assuming a uniform deleveraging across domestic and external claims.

14. The direct losses to Finnish banks remain mild even if assets held also on banks and nonbanks default. In fact, even if Finnish banks lose 30 percent of their assets in the three program countries, the loss to the Finnish banking sector would be small. In particular, the Finnish banking sector’s ability to extend credit to the economy would remain largely intact.

15. More sizable losses could be incurred due to exposures to Sweden and Germany. In contrast with the earlier example, the following table shows how the Finnish banking sector is more vulnerable to losses recorded on German and Swedish assets. For example, a 10 percent decline in the asset value held on Germany and Sweden could result in losses for Finnish banks of around ½ and 2 percent of GDP, respectively. In addition, the 10 percent loss on Swedish assets alone could induce a credit squeeze. In the absence of corrective policy measures, credit availability may contract by more than 50 percent of GDP. In turn, this could have severe second round effects for overall GDP growth, well beyond the losses to the Finnish banks. The large impact on credit availability underpins the importance of exposure to cross-border activities of Swedish banks active in Finland.

Spillovers to Finland from International Banks’ Exposures(As of September 2011)
Shock originating fromMagnitude 1/Deleveraging

need 2/
Finnish banks’

losses (percent

of GDP)
Impact on credit

availability (percent

of GDP) 3/
Greece300.00.0−0.1
Greece, Ireland and Portugal300.00.1−0.7
Italy100.00.1−0.4
Spain100.00.1−0.9
France100.00.2−3.3
Germany100.00.6−5.1
Sweden100.01.9−56.5
UK100.00.4−2.6
Selected European Countries 4/1055.83.6−71.6
US100.00.3−4.4
Sources: RES/MFU Bank Contagion Module based on BIS, ECB, and IFS data.

Magnitude denotes the percent of on-balance sheet claims (all borrowing sectors) that default.

Deleveraging need is the amount (in percent of Tier I capital) that needs to be raised through asset sales in response to the shock in order to meet a domestic banking sector Tier I capital asset ratio of 10 percent, expressed in percent of total assets and asuming no recapitalizations.

Reduction in foreign banks credit to Finland due to the impact of the analyzed shock on their balance sheet, assuming a uniform deleveraging across domestic and external claims.

Greece, Ireland, Portugal, Italy, Spain, France, Germany, Sweden, and the United Kingdom.

Sources: RES/MFU Bank Contagion Module based on BIS, ECB, and IFS data.

Magnitude denotes the percent of on-balance sheet claims (all borrowing sectors) that default.

Deleveraging need is the amount (in percent of Tier I capital) that needs to be raised through asset sales in response to the shock in order to meet a domestic banking sector Tier I capital asset ratio of 10 percent, expressed in percent of total assets and asuming no recapitalizations.

Reduction in foreign banks credit to Finland due to the impact of the analyzed shock on their balance sheet, assuming a uniform deleveraging across domestic and external claims.

Greece, Ireland, Portugal, Italy, Spain, France, Germany, Sweden, and the United Kingdom.

16. Our contagion estimates indicate potential weaknesses from specific exposures, but indirect effects associated with a default in any country are likely to be much larger. Although the simulations take into account second round deleveraging effects, the results abstract from likely effects on confidence, asset prices, and implications of a potential default by a sovereign or bank for the functioning of the interbank market. Even more importantly, banks’ deleveraging would impact GDP, which could also translate into additional further bank losses through an increase in non-performing assets. These effects could potentially be much more damaging than any direct spillover.

E. Conclusion

17. Finland differs from other small open euro area countries through its strong trade and financial ties to non-euro area countries. The Finnish banking sector is dominated by Danish and Swedish banks and the FDI in Finland is mainly from Sweden. Trade is less concentrated on euro area members than is the case for other members of the currency union.

18. While global fiscal consolidation and a euro area growth shock have moderate impacts on Finland, downward risk stems from the strong trade and financial ties with Sweden. Developments in the euro area countries are of more limited relevance to Finland than is the case for other euro area countries. Weaker trade and financial ties with the euro area countries reduce the transmission of shocks to growth in these countries. However, links to Sweden are very strong and shocks to the Swedish growth rate or the Swedish banking sector are likely to have large repercussions in Finland, with 1 percentage point lower growth in Sweden in 2012 dragging down Finnish GDP growth in 2013 by more than ½ percentage point.

F. References

    CeruttiEugenioStijnClaessens and PatrickMcGuire2012Systemic Risks in Global Banking: What can Available Data Tell Us and What More Dare are Needed?BIS Working Paper 376Bank for International Settlements.

    IvanovaAnna and SebastianWeber2011Do Fiscal Spillovers Matter?IMF Working Paper 11/211Washington: International Monetary Fund.

    PoirsonHelene and SebastianWeber2011Growth Spillover Dynamics from Crisis to RecoveryIMF Working Paper 11/218Washington: International Monetary Fund.

    TresselThierry2010. “Financial Contagion through Bank Deleveraging: Stylized Facts and Simulations Applied to the Financial CrisisIMF Working Paper 10/236Washington: International Monetary Fund.

Appendix 1.1. A Measure of the Effect of Global Consolidation on Growth

The representation of the national accounts and behavioral assumptions for government spending, taxes, consumption, investment, exports, and imports can be used to simulate the effect of consolidation on growth. The starting point is the national accounting identity:

where, Yt,j is real output, It,j is real investment, Gt,j is real government spending, Xt,j are real exports and Mt,j are real imports, in all cases of country j in time t denominated in a common currency for a sample of N countries. The individual components of output are:

where μi is the marginal propensity to import of a trading partner i, Yi is the output of a trading partner i, and ωij is the weight of imports from country j in total imports of country i. Government expenditures and revenues have a cyclical part and a discretionary element. Substituting definitions (2) in (1) yields:

Where ext,j = C0 + I0d2rt,j and mj = (1-c1d1g1 + t1 + μj)-1 is the expenditure multiplier. Taking the first difference and dividing by real output in t-1 yields the growth rate:

Equation (4) is a system of N linear equations that can be written in matrix notation:

Here W = (IB)-1 is an N-by-N identity matrix, B is a N-by-N matrix, is N-by-1 vector of real GDP growth rates, A1 and A2 are diagonal N-by-N matrices and G¯t and T¯ are N-by-1 vectors. Country i’s contribution to country j’s GDP growth is given by evaluating:

The sample of countries includes: Austria, Belgium, China, Finland, France, Germany, Greece, India, Ireland, Italy, Japan, Korea, Netherlands, Portugal, Russia, Spain, Sweden, Switzerland, United Kingdom, and the United States. This sample of countries accounts for more than 80 percent of Finnish exports. The fiscal impulse is measured by the change in the cyclical adjusted revenues and expenditures relative to GDP. Details on the other assumptions are provided in Ivanova and Weber (2011).

Appendix 1.2. Contagion Module - A Simulation of Downstream Risk from Defaults8

The analysis is based on several rounds of shocks. The first round considers bank losses on assets that deplete their capital partially or fully. The banking sector losses are calculated based on percentage loss assumptions in a particular economic sector (public sector, banking sector, and/or non-bank private sector) of an individual country or group of countries. In the second round, if losses are large enough, a capital ratio is assumed to be restored through deleveraging (loans not being rolled over and selling of assets, assuming no recapitalization). In the third round, banks are assumed to reduce their lending to other banks, causing fire sales, and further deleveraging. Potential bank failures cause additional losses to other banks on the asset and liability sides. Final convergence is achieved when no further deleveraging needs to occur. Methodological details may be described by the following set of equations: 9

The analysis of the contagion of a crisis across borders and through common lender effects is based on considering a stylized bank balance sheet given by:

Assets = Capital + Other _ Liabilities

where Assets = Foreign _ Assets + Domestic _ Assets. To quantify the effect of a shock on assets, it is assumed that, when facing a loss of LLR percent on its foreign assets, a bank combines asset sales DEL and recapitalization RECAP to maintain a sound capital to asset ratio or CAR. For a given loss on its asset portfolio, the set of possible combinations of deleveraging (asset sales) and recapitalization is given by:

CapitalLLR ⋅ Foreign _ Assets + RECAP = CAR ⋅ (Assets − LLR ⋅ Foreign _ AssetsDEL)

Hence, in the absence of a recapitalization of the banking sector, the extent of deleveraging by the financial institutions of a creditor country is given by:

The process of deleveraging results in a global reduction of cross-border claims by all international banks affected by the shock, either directly or indirectly. For each recipient country, the extent of capital outflows is the aggregation of the deleveraging process by all creditor countries. Additional rounds of deleveraging may take place if shocks are large enough to cause international banks’ insolvencies, and if fire sales of assets occur, triggering further losses. The system converges to an equilibrium when no further deleveraging takes place.

Prepared by Sebastian Weber.

The implementation of Basel III could further increase linkages across countries as Finland-based banks are likely to turn to foreign funding to increase long-term equity capital eligible as Tier 1 capital instruments under the more stringent Basel III definitions.

In addition, the upstream exposure measure also includes the credit commitments (not used yet) that a borrower country has secured from BIS reporting banks.

For a detailed description see Ivanova and Weber (2011). A brief discussion is provided in Appendix A.

Results underestimate the impact on growth as there is no second-round effect on other countries’ dynamic domestic component but only on their external dynamic component. However, the approach has the advantage that it takes third country effects—e.g. the impact on Finland of the fall in Italian domestic demand channeled via Germany—into account and is thus estimating the spillover effects consistently across the 17 countries in the sample. The foreign component includes also three exogenous shocks: a dummy for the oil shock in 1979, a dummy for the oil shock in 1990, and a dummy for the recent financial crisis. The sample extends from 1975Q1 to 2011Q4. The country sample includes: Austria, Belgium, Canada, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

High spread countries are countries with spreads above the 10-year government bond yield of the Bund of more than 100 basis points at 2011Q1. These countries include Greece, Ireland, Portugal, Italy, and Spain.

See Cerutti et al. (2012) and Tressel (2010) for methodological details. A brief discussion is provided in Appendix B.

Prepared by Eugenio Cerutti.

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