CEPII, Recherche et Expertise sur l'economie mondiale
Banking Leverage Procyclicality: a Theoretical Model Introducing Currency Diversification


Justine Pedrono

 Highlights :
  • This paper offers the first theoretical model investigating the procyclicality of banking leverage relative to the currency diversification of banks' balance sheet.
  • Using a contracting model between a representative bank and its creditor, we show that currency diversification still allows banks to follow a Value-at-Risk rule.
  • Currency diversification changes banks’ leverage adjustment in response to economic fluctuation. The impact on leverage procyclicality then depends on the type of shock.
  • Introducing a floating exchange rate regime increases the fund-raising capacity of banks when shocks are not symmetric.

 Abstract :
The brutal adjustments to global banks' balance sheets in the wake of the recent economic crisis have rekindled interest in the procyclicality of banking leverage. This paper extends Adrian and Shin (2014) by allowing banks to hold assets and liabilities denominated in foreign currency. It investigates the procyclicality of banking leverage relative to the currency diversification of banks' balance sheet. Therefore, it provides a complete theoretical framework that explains heterogeneity in financial cycles when focusing on currency exposures. Our results show that the Value-at-Risk rule followed by banks is still validated when currency diversification is introduced. However, currency diversification changes leverage procyclicality where the decrease or increase in leverage procyclicality relative to the home economy will depend on the type of shock. To the extent that changes in state of nature are asymmetric, currency diversification of assets associated with floating exchange rate regime then increases the risk-taking capacity of banks.

 Keywords : Financial intermediary | leverage | procyclicality | currency | diversification | Value-at-Risk | exchange rate

 JEL : f36, g15, g21, g32
CEPII Working Paper
N°2017-06, April 2017

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Monnaie & Finance
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