The Dollar, Bank Leverage, and Deviations from Covered Interest Parity

The full text used here is BIS Working Paper No. 592 (revised July 2017), the freely available version of the paper published in American Economic Review: Insights in 2019. The question it takes up is why apparently risk-free arbitrage opportunities persist in the largest currency market in the world, and its answer begins with an observation about what the textbook argument leaves out: “in textbooks, there are no banks. In practice, though, such arbitrage typically entails borrowing and lending through banks, and the competitive assumption is violated due to balance sheet constraints that place limits on the size of the exposures that can be taken on by banks. Even for non-banks, their ability to exploit arbitrage opportunities rely on banks to provide leverage. Hence, if deviations from CIP persist, it must be because banks do not or cannot exploit such opportunities.” From there the paper documents a “triangular relationship” joining the strength of the dollar, the cross-currency basis and cross-border dollar bank lending, and argues that all three are readings of one thing: the shadow price of bank leverage, for which the dollar spot rate serves as a barometer. The evidence has four parts. First, time-series regressions on the ten most liquid currencies against the dollar (Australian, Canadian and New Zealand dollars, Swiss franc, Danish and Norwegian krone, euro, pound, yen, Swedish krona) over 1 January 2007 to 2 February 2016: a one percentage point appreciation of the broad dollar index is associated with a 2.6 basis point fall in the three-month basis without controls and 2.1 with them, against a 7 basis point standard deviation of daily basis changes; at quarterly frequency the five-year basis coefficient runs -1 to -1.4, so a one standard deviation move in the index (3 percent) implies a 3-4 basis point reduction, and the dollar alone explains 19 percent of the time-series variation. Results are similar and more significant in a post-January-2009 subsample, so they are not a crisis artefact. Second, an asset-pricing result in the cross-section: currency-specific dollar betas correlate with the mean basis at 85 percent for the three-month and 97 percent for the five-year horizon, with a unit increase in beta magnitude corresponding to 11 and 26 basis points of expected CIP-trade return respectively – and with a striking reversal of roles, since “the classical ‘safe haven’ currencies, such as the Japanese yen and the Swiss franc, have the highest exposure to the dollar factor, and high-yielding ‘carry’ currencies, such as the Australian dollar and the New Zealand dollar, have the lowest.” An out-of-sample event study of the 3.9 percent dollar appreciation between 8 and 29 November 2016 confirms it: the basis widened for all G10 currencies, most for the yen (from -70.3 to -90.5 basis points), and the post-election dollar beta correlates with the basis at 98 percent. Third, panel regressions with borrowing-country fixed effects show quarterly growth in dollar-denominated cross-border lending falling with both the broad dollar index and the bilateral rate, jointly and separately, for all sectors and for bank and non-bank borrowers alike – evidence, the authors argue, that the index “has explanatory power over and above the bilateral dollar exchange rate.” Fourth, 51 internationally active G10 banks: a 1 percent broad dollar appreciation goes with a 2 percent decline in bank equity, falling to 0.27 percent once market returns are controlled for, and the interaction with the five-year basis is significantly positive, so banks in currency areas with a more negative basis suffer more. The mechanism offered is the risk-taking channel of Bruno and Shin, in which a weaker dollar flatters dollar borrowers’ balance sheets, reducing tail risk in creditors’ portfolios and freeing capacity under a value-at-risk constraint; this is what the authors call the financial channel of exchange rates, and they emphasise that it “may operate in the opposite direction to the net exports channel.” The triangle is shown to hold for the euro in the post-crisis sample but not for other major currencies, which the authors read as pointing “to the unique role of international funding currencies.”

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The Dollar, Bank Leverage, and Deviations from Covered Interest Parity