Breaking the trilemma: the effects of financial regulations on foreign assets

Summary

Focus

How can financial constraints affect the exchange rate? We propose a theoretical model to address this question, using high-frequency data on Colombian banks to test its predictions.

Contribution

We use a simple theoretical model to analytically evaluate the impact of banking limits on the equilibrium exchange rate. We thereby characterise the portfolio balance channel. We then use high-frequency data from Colombian banks to empirically test the model's predictions. Our data cover every financial institution in the 2004-15 period, and various measures of portfolio balances. We also use data on official foreign exchange intervention that let us analyse the effect of banking portfolio holdings, and to address whether foreign exchange intervention is an effective monetary tool, and under what conditions. Finally, our identifying strategy is based on the way that regulatory authorities imposed banking limits on foreign holdings. Intuitively, a break in the policy measure creates a natural experiment in which financial institutions arbitrarily face binding constraints as long as they are close to the required limit.

Findings

The decision to hold domestic or foreign assets is relevant depending on whether financial constraints are binding. In the case where constraints bind, portfolio compositions affect the equilibrium exchange rate and foreign exchange interventions are effective. This is not the case when constraints are not binding. Consistent with this hypothesis, in the empirical application we find that effects of financial restrictions on the exchange rate are short-lived, and significant only when banking limits bind. Moreover, we find significant effects on portfolio balances when banks are faced with binding constraints. Finally, we find that exchange rate effects are larger in episodes when Colombia's central bank intervened in the foreign exchange market.

Abstract

In this paper we analyze the effects of financial constraints on the exchange rate through the portfolio balance channel. Our contribution is twofold: First, we construct a tractable two-period general equilibrium model in which financial constraints inhibit capital flows. Hence, departures from the uncovered interest rate parity condition are used to explain the effects of sterilized foreign exchange intervention. Second, using high frequency data during 2004-2015, we use a sharp policy discontinuity within Colombian regulatory banking limits to empirically test for the portfolio balance channel. Consistent with our model's postulations, our findings suggest that the effects on the exchange rate are short-lived, and significant only when banking constraints are binding.

JEL classification: C14, C21, C31, E58, F31

Keywords: Sterilized foreign exchange intervention, portfolio balance channel, uncovered interest rate parity, financial constraints, regression discontinuity design