Staff Report, Federal Reserve Bank of New York 633
Banks play a critical role in facilitating international trade by guaranteeing international payments and thereby reducing the risk of trade transactions. This paper uses banking data from the United States to document new empirical patterns regarding the use of letters of credit and similar bank guarantees. The analysis shows that the volume of banks' trade finance claims differs substantially across destination countries. Controlling for exports, claims are hump-shaped in country credit risk and increase with the time to import of a destination market. They also vary systematically with global conditions, expanding when aggregate risk is higher and funding is cheaper. The response to changes in these macro factors is not uniform. Trade finance claims adjust the least in countries with intermediate levels of risk, which rely the most on letters of credit to settle payments. We show that a modification of the standard model of payment contract choice in international trade is needed to rationalize these empirical findings.