Global bank lending and exchange rates

Summary

Focus

We estimate the impact of banks' cross-currency lending on exchange rates to shed light on the importance of flows as a major force affecting foreign exchange (FX) market outcomes. To rationalise our findings, we focus on the funding mechanism for how globally active banks source liquidity when granting loans in another currency such as the US dollar. When a foreign bank grants a cross-currency US dollar loan, it needs to obtain US dollar liquidity, which puts pressure on funding markets and leads to an appreciation of the US dollar. We focus especially on the aftermath of the 2008–09 financial crisis, which has seen not only a tightening of banking regulation but also structural shifts in US dollar funding markets.

Contribution

Using an extensive dataset of syndicated lending relationships spanning 2000 to 2021 and a large set of currency areas, we use a granular instrumental variable (GIV) approach to identify the impact of bank lending flows on exchange rates. In addition to examining exchange rate movements, we delve into the underlying funding mechanisms behind cross-currency syndicated loans, highlighting their impact on global FX swap markets and the subsequent effects on covered interest parity (CIP) deviations.

Findings

Our study finds that flows of cross-currency lending have a substantial and statistically significant effect on exchange rates, particularly in the post-crisis period. We detect a 36 basis point appreciation in the US dollar for a one standard deviation increase in net US dollar lending flows. Further analysis of the funding mechanisms shows that the effects of flows on exchange rates are stronger when intermediary balance sheets and funding are constrained. Additionally, we find that cross-currency lending flows affect key funding markets, such as the FX swap market and the US dollar market for commercial paper and certificates of deposit. These findings contribute to a general understanding of the interplay between global bank lending flows, exchange rates and funding markets. They provide valuable insights for academics and policymakers researching the intricacies of international financial markets and spillover effects.

Abstract

We estimate the impact of banks' cross-currency lending on exchange rates to shed light on the importance of flows as a major force affecting FX market outcomes. When non-US banks extend more loans in US dollars (USD) relative to US banks  originating foreign currency-denominated loans, the USD appreciates significantly. When a foreign bank grants a cross-currency USD loan, it needs to obtain USD liquidity which puts pressure on funding markets and leads to an appreciation of USD. This effect – which we estimate via a granular instrumental variable approach – has greatly intensified since the global financial crisis and crucially depends on how banks fund the provision of cross-currency loans. In line with this mechanism, we show that cross-currency lending also affects the FX swap market (and deviations from covered interest parity), as well as other segments of the US short-term funding market.

JEL classification: F31, E44, G21

Keywords: cross-currency lending, exchange rates, granular instrumental variable, CIP deviation