International Trade, Risk and the Role of Banks

Banks play a critical role in facilitating international trade by guaranteeing international payments and thereby reducing the risk of trade transactions. This paper employs banking data from the U.S. to document new empirical patterns regarding the use of letters of credit and similar bank guarantees. The analysis reveals that trade finance is a large and highly concentrated business. It corresponds to roughly 20 percent of U.S. exports, with the top five banks extending more than 90 percent of the guarantees. We find that exporters use letters of credit the most when exporting to countries with intermediate levels of risk. Moreover, they rely more on this instrument in times when funding is cheap and aggregate uncertainty is high. However, firms do not respond uniformly to changes in global interest rates and risk. Those that ship to high and low risk countries adjust their use of letters of credit the most. A modification of the standard model of payment contract choice in international trade is needed to rationalize these empirical findings.