The currency channel of the global bank leverage cycle

Keywords Bank; Financial cycles; Leverage; Internationalization; International portfolio; Currency Highlights * International diversification induces both a currency and a risk channel for banks. * The risk channel raises the tail risk of banks when the home economy performs best. * The currency channel lowers the tail risk, boosting banks' fund-raising capacity. * During the GFC, the currency channel helped reduce banks' leverage procyclicality. Abstract The amplitude of leverage procyclicality is heterogeneous across banks and across countries. This paper introduces international diversification of bank balance sheets as a factor in this observed heterogeneity, with a special emphasis on currency diversification. Based on a new theoretical framework, it shows that the impact of international diversification on leverage procyclicality depends on the relative performance of economies, the global business cycle and the exchange rate regime. By altering the distribution of global bank portfolios, international diversification adds a currency channel to the risk channel of the global leverage cycle. Using granular data on banks located in Prance, the paper shows that the pre-crisis international diversification of banks increased leverage procyclicality during the 2008--2009 crisis. Focusing on the currency channel, namely the valuation effect of currency diversification, my results show that it had a negative effect on leverage procyclicality during this period. The currency channel thus helped to offset part of the increased risk caused by the crisis. These findings draw attention to the specific role of balance sheet currency diversification in financial stability risk. Author Affiliation: Banque de France, 39 rue Croxi des Petits Champs, 75001 Paris, France (footnote)[white star] I am very grateful to Mohamed Belhaj, Agnes Benassy Quere, Benjamin Carton, Nicolas Coeur-dacier, Nuno Coimbra, Olivier de Bandt, Reint Gropp, Jean Imbs, Dirk Krueger, Patrick Pintus, Hyun Song Shin, Cedric Tille, Belinda Tracey, Helene Rey as well as participants at the ECB's Sintra forum (2015), the IWFSAS (2017), the annual AFSE congress (2018) and the 4th BoE-BdF International Macroeconomics Workshop (2018), and seminar participants at the AMSE, the CEPII, the Paris Dauphine University Macro Finance Seminar, the PSE and the Banque de France for very helpful comments. The views expressed here are those of the author and do not necessarily represent those of the Banque de France. Byline: Justine Pedrono [justine.pedrono@banque-france.fr]