The Flight Home Effect

The following post comes to us from Mariassunta Giannetti, Professor of Finance at the Stockholm School of Economics, and Luc Laeven of the International Monetary Fund and Professor of Finance at Tilburg University.

In our paper, The Flight Home Effect: Evidence from the Syndicated Loan Market During Financial Crises, forthcoming in the Journal of Financial Economics,  we study whether lenders, when hit by shocks that negatively affect bank wealth in their home market, have a tendency to rebalance their portfolio away from international markets to their domestic market. We explore this flight home effect in the context of the syndicated loan market, a large and highly internationalized financial market.

After controlling for demand shocks in foreign markets, we explore whether foreign lenders not only transmit shocks to foreign markets, as established in existing literature, but also whether they amplify these effects by substituting foreign loans for domestic loans. To establish whether this is the case, we analyze how the relative importance of a bank’s domestic and foreign loans varies following negative shocks.

Our results are consistent with the existence of a flight home effect. The proportion of loans granted to domestic borrowers increases by approximately 20 percent if the home country of the bank experiences a banking crisis, or more generally, if banks’ stock prices in the home country show a large decline. Lenders with less stable funding sources, being more vulnerable to negative liquidity shocks (Demirgüç-Kunt and Huizinga, 2010; Ivashina and Scharfstein, 2010), exhibit a stronger flight home effect. Overall, the results indicate that the home bias in the international allocation of syndicated loans increases in the presence of adverse economic shocks affecting the net wealth of international lenders.

The flight home effect is different from the flight to quality effect highlighted in existing literature (Bernanke et al., 1996; Lang and Nakamura, 1995). We show that the flight home effect is not driven by international banks’ desire to rebalance their portfolios towards higher quality borrowers when faced with negative shocks. Banks rebalance their portfolio away from foreign borrowers, irrespective of whether or not these borrowers are affected by a banking crisis in their home country. Similarly, the flight home effect is not limited to borrowers with lower credit ratings or to countries with weak creditor protection, and does not depend on the institutional environment of the home country of the lender.

Our results suggest that the degree of proximity to the domestic market affects the perceived risk and expected returns of banks experiencing negative shocks. This could be for a number of reasons. First, the cost of negotiating and monitoring syndicated loans may be higher for foreign loans. Therefore, when reducing exposure in response to negative shocks, banks may revert to more profitable domestic markets. Second, in response to negative shocks, banks face increased uncertainty regarding their ability to meet their capital requirements and, as a result, their effective risk aversion increases. If banks are also less able to evaluate foreign borrowers and view them as riskier, they may extend fewer foreign loans in response to negative shocks, as models of home bias based on ambiguity aversion would imply (Epstein, 2001).

The full paper is available for download here.

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