Exchange Rate Risk, Banks' Currency Mismatches, and Credit Supply
36 Pages Posted: 18 Nov 2019 Last revised: 5 Jan 2023
Date Written: December 21, 2022
We exploit the post-Brexit depreciation of the British pound as an exogenous shock to show how exchange rate shocks transmit to the German real economy through the banking sector. German banks with GBP currency mismatches (between assets and liabilities, including off-balance sheet items) suffer losses when the currency of assets depreciates relative to that of liabilities, which they internalize by cutting back credit supply. For a one percentage-point loss in equity, a bank cuts credit supply by 73 basis points on average, with stronger effects for banks with lower equity capital. The credit contraction of German banks (i) affects also firms that are not directly related to UK conditions, (ii) holds across all industries, including non-tradable sectors, (iii) impacts relatively more small borrowers, and (iv) decreases affected firms’ investments.
Keywords: Currency Mitmatch, Credit Supply, Foreign Exchange Risk, Financial Intermediation, Risk Migration, Financial Stability
JEL Classification: D53, D61, F31, G15, G21, G32
Suggested Citation: Suggested Citation