Exchange rate movements and bank lending

Recent exchange rate volatility has drawn attention to the impact that sharp exchange rate movements can have on banks’ balance sheets and therefore their profitability, which is a concern for supervisors and financial stability authorities.  Moreover, such exchange rate fluctuations can also influence bank lending and therefore the real economy.  Traditionally, studies using standard open-economy macroeconomic models show that a fall in the exchange rate raises local GDP via higher net exports, but they ignore the role of banks as important transmitters of such shocks. Empirical evidence has shown, however, that exposure of firms and financial institutions to foreign-currency assets and liabilities can play an important role in the effect of exchange rate movements in the real economy (Bruno and Shin, 2015; Bruno and Shin, 2020).

In a recently accepted paper (Beck et al., 2025) we test the effect that such exchange rate movements and consequent changes in the solvency position of banks can have on their lending and on the real economy using the 2014 depreciation of the euro vis-à-vis the US dollar. We rely on matched bank-firm-level data from Germany and estimate difference-in-differences regressions between 2014 Q2 and 2015 Q1, during which the euro depreciated by more than 20% vis-a-vis the US dollar. This depreciation was to a large extent driven by tapering of Fed QE policies and implementation by the ECB of a more expansionary monetary policy.

We find that the exchange rate drop raised the net worth of banks but it only directly affected a few large banks with significant foreign exchange rate positions. These large banks did not increase their lending to non-financial firms but instead increased their interbank credit supply to small local banks without significant foreign-currency asset exposure but with a high share of exporting firms in their loan portfolios. These smaller banks ultimately passed on this credit supply to (exporting) borrowers.  This is evidence that a fall in the exchange rate, by increasing the liquidity of distinct tiers in the domestic banking sector, can have sizeable economic effects, even when local banks have low foreign-currency asset exposure and are therefore not directly affected by the exchange rate shock.

In terms of real effects, we show that exporting firms borrowing from smaller banks that have higher interbank market dependence increased their investment following the exchange rate drop, and that regions with local banks benefiting from this increase in interbank borrowing experienced significantly higher GDP growth than less exposed regions. While some of this effect might be driven by the classic trade (firm demand) channel with more export-dependent firms typically experiencing higher demand following domestic currency depreciation, even after controlling for firm demand effects more exposed regions cumulatively grew by 1.3-1.4 percentage points more than less exposed regions in the two years after the depreciation relative to the two pre-depreciation years.

Overall, these findings show the importance of the balance sheet structure of banks in transmitting exchange rate shocks to the real economy. Critically, the interbank market can play an important role in transmitting such macroeconomic shocks to parts of the banking system that are not directly exposed to exchange rate movements.  As Europe is bracing itself for more volatility, including exchange rate volatility, it is important to understand the role of the banking system as a transmission channel of such volatility to the real economy.

References

Beck, T., P. Bednarek, D. te Kaat and N. von Westernhagen (2025), “Real Effects of Exchange Rate Depreciation: The Roles of Bank Loan Supply and Interbank Markets” Journal of Money, Credit and Banking, forthcoming.

Bruno, V. and H. S. Shin (2015), “Cross-Border Banking and Global Liquidity,” Review of Economic Studies 82, 535-64.

Bruno, V. and H. S. Shin (2020), “Currency Depreciation and Emerging Market Corporate Distress,” Management Science 66, 1935-61.