The dollar, bank leverage and the deviation from covered interest parity

We document the triangular relationship formed by the strength of the US dollar, cross-border bank lending in dollars and deviations from covered interest parity (CIP). A stronger dollar goes hand-in-hand with bigger deviations from CIP and contractions of cross-border bank lending in dollars. Differential sensitivity of CIP deviations to the strength of the dollar can explain cross-sectional variations in CIP arbitrage profits. We argue that underpinning the triangle is the role of the dollar as proxy for the shadow price of bank leverage.

JEL classification: F3, G1, G2

Keywords: exchange rates, bank leverage, cross-currency basis
 

• Addendum to WP592 (5 December 2016)