The Currency Composition Channel of Monetary Policy and the Role of Macroprudential Regulation

Abstract

We examine how domestic and foreign monetary policy affect the supply of bank credit when bank lending is denominated in domestic and foreign currencies, and how domestic macroprudential regulation shapes the transmission of foreign monetary spillovers. We use a country-level and a bank-level dataset from several European emerging economies on the lending activities of local banks broken down by currency denomination. We merge this information with indicators of monetary and macroprudential policy actions, and with bilateral trade linkages between countries. We document three main results. First, there exists a domestic currency composition channel of monetary policy: domestic monetary changes affect the share of lending in foreign currency in the domestic banking sector. Second, monetary shocks transmit across countries through international trade networks giving rise to an international bank lending channel in its currency dimension. Third, macroprudential policies enacted in home lending banking systems partly offset the spillover effects of monetary policies initiated abroad, suggesting an active role for macroprudential regulation in shielding the home economy from foreign shocks.