Cross-border linkages of banks can transmit liquidity shocks from one country to another. This has become obvious during the recent financial crisis, where internationally active banks played an important role in the transmission of shocks. A liquidity shock can be transferred from one country abroad to the domestic country due to three possible channels. Firstly, the liquidity shock abroad can be transferred through a reduction of direct cross-border loan supply by foreign banks. Secondly, due to the liquidity shock abroad, local affiliates of a foreign-owned bank can reduce their lending activities in the host country. This can be attributed to the fact that globally active banks are able to reallocate their funds across borders. Thus, they can better compensate liquidity shocks at home by reallocating funds from their foreign affiliates to their head office. Thirdly, a liquidity shock abroad can be transmitted through domestic banks due to a reduction of local lending. This might happen if banks located in the country in which the liquidity shock originates adjust their cross-border activities. As a result cross-border interbank lending might decline such that domestic banks face a funding shock to their balance sheet. This, in turn, might induce a reduction of domestic loan supply.
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