Banks' Foreign Currency Exposure and the Real Effects of Exchange Rate Shocks

Abstract

In contrast to standard theory, recent empirical evidence shows that currency depreciations are not always expansionary. I show that a bank lending channel of exchange rates can explain this disconnect. I provide causal evidence on the importance of this channel using a large and unanticipated currency appreciation shock from Switzerland. I construct a novel dataset on foreign currency exposure of Swiss banks and bank-firm relationships, and show that the currency appreciation shock enabled banks with net foreign currency liability exposure to increase lending, allowing firms to increase investment. The bank lending channel thus partially offsets the negative effect of currency appreciation on exports, explaining the muted response of aggregate output to the shock. I also construct a new historical database on banks' foreign currency exposure for a sample of 43 countries and provide evidence on the general importance of this channel across historical global currency depreciations.

Keywords: Bank Lending, Exchange Rates, Currency Mismatch, Open Economy

JEL Classification: G15, G21, F30, F65