Exchange Rate Risk, Banks' Currency Mismatches, and Credit Supply

Abstract

This paper shows that banks have unbalanced on- and off-balance-sheet currency exposure, which affects the economy profoundly when the inherent exchange rate risk materializes. Even if banks’ net foreign currency exposure is zero in the aggregate, across-banks heterogeneity can lead to a reduction in economic activity: an adverse exchange rate shock induces losses from currency mismatches, leading to a contraction in credit supply as capital constraints bind. This hampers the ability of firms (especially small ones) to borrow and invest, including those unlikely to have had any exchange rate exposure to begin with. These findings highlight that exchange rate risk in combination with currency mismatches at banks is a source of shock propagation with severe macroeconomic implications.