WASHINGTON The euro zone crisis reduced the dollar lending of European banks as doubts over their credit-worthiness made their access to dollar funding more expensive, according to a Federal Reserve research paper published on Wednesday.
The study, co-authored by Fed Governor Jeremy Stein and two Harvard economists, stopped short of arguing that the European crisis caused U.S. credit conditions to tighten and said U.S. and other foreign banks could have filled the lending gap.
But it did examine a channel that could transmit shocks outside the United States into the domestic economy in a way that limited the ability of U.S. firms to borrow.
"Although dollar lending by foreign banks increases the supply of credit to U.S. firms during normal times, it may also prove to be a more fragile source of funding that transmits overseas shocks to the U.S. economy," the study said.
President Barack Obama, for whom the economy is a make-or-break issue in his bid to hold onto the White House in the U.S. election on Tuesday, has called the European crisis one of the most severe headwinds holding back the country's recovery.
It has contributed to U.S. business uncertainty that is deterring investment and hiring, despite ultra-low borrowing costs after the Fed cut interest rates almost to zero and launched massive bond buying programs to drive down yields.
The paper explored the consequences for dollar lending by European banks after rating agencies highlighted the risks to the credit quality of some of the largest European lenders posed by the crisis, and warned that they might be downgraded.
Such institutions rely heavily on the wholesale, uninsured credit market for dollar funding, but can raise euro funds from their domestic retail bank networks, where deposits are insured.
As a result, dollar funding costs for these banks grew, compared with euro funding costs, and the dollar liabilities of euro zone banks sank by over a third between May and August 2011, to $287 billion from $453 billion.
This happened even though European banks could use their euros to buy dollars for making loans to their own customers, because that requires hedging in foreign exchange markets, which also became more costly as demand for that dollar-forward trade rose.
"Dollar lending by Eurozone banks fell relative to their euro lending, while this was not the case for U.S. banks," the authors said, citing data from Thomson Reuters DealScan. "Adverse shocks to creditworthiness led them to curtail their supply of dollar loans, relative to their supply of loans in their domestic currency."
Although they indicated that they thought this could potentially be the case, the authors spelled out that they had not investigated whether the reduction in dollar lending by European banks resulted in a tightening in overall credit for U.S. firms, and thereby held back the economy overall.
"The ultimate cost of Eurozone bank retrenchment on dollar borrowers is difficult to assess at this point," they said, urging more research on the subject. (Reporting by Alister Bull; Editing by Chizu Nomiyama and Dan Grebler)