Capital Inflows To U.S. Banks Actually Make Sense

 |  Includes: KBE, XLF
by: IPE at UNC

By Kindred Winecoff

Via TC, a data point that reinforces some research that the IPE@UNC crew has been conducting:

MFIs in Europe have drained their bank accounts at European banks by about €700 billion over the past year and half, which at current exchange rates is approximately $1 trillion. It seems that much of that money has recently found its way into the bank accounts that European MFIs keep in US banks. And conversely, it seems likely that the large inflow of cash deposits held at US banks this year is largely from European banks.

Putting it all together yields a compelling story: European banks are shifting their cash assets out of European banks and putting much of them into US banks. This has happened at a significant rate, with a net transatlantic flow from European to US banks that probably totals close to half a trillion dollars in just six months.

Given all of the trouble in the US banking sector over the past four years, and given the recent S&P shot at the U.S., why would foreign funds continue to flow into the US rather than, say, emerging economies that continue to grow at high rates? This sort of behavior is not expected by most political science, economics, or finance research or by many in the pundit and investing classes.

One answer may be found by examining the network dynamics embedded in the international banking system, one representation of which is on the right. This graphs in-degree, which are bank holdings from country i to country j. Tie strength is the amount of holdings, node size is cumulative in-degree from all countries in the network. (Click here for animation of the graph.)

The international banking network is highly unequal, with the US as the most central node in the system. Highly unequal networks have different dynamics than other networks, one of which is a "preferential attachment" rule for organizing links between nodes. The rule states that, because of network externalities, nodes that attract a lot of links will tend to attract even more links in the future. Thus, the structure of the network is stable and self-reinforcing.

The US has attracted by far the most foreign bank holdings throughout the entire data series, and the intensity of these links has increased (in nominal terms) over time. That process hesitated briefly at the height of the financial crisis before resuming. So given the structure of the network and the dynamics that that structure implies, increased flows into the US -- especially during times of trouble like those currently plaguing Europe -- is exactly what we should expect. If we didn't continue to see this behavior, that's when we would need to start looking for major changes to the organization of the global economy.