Banks borrow in order to lend, and so their lending capacity depends on their ability to borrow. When wholesale funding is the margin of adjustment for bank leverage, capital market conditions exert a large impact on bank lending capacity. The VIX index had previously served as the barometer of the appetite for leverage, but this is no longer true. Instead, the dollar has emerged as a barometer of that appetite for leverage. When the dollar is strong, banks’ risk appetite is subdued and market anomalies, such as the breakdown in covered interest parity, become more pronounced. This phenomenon has implications both for financial stability and for the real economy. If banks are reluctant to lend during largely tranquil times, what will happen when volatility picks up? The effects of the strong dollar on funding costs may also shed light on aspects of the real economy, such as the slowdown in international trade.
The full speech is available here.
