The Bank for International Settlements (BIS) published a report that estimates the impact of banks’ cross-currency lending on exchange rates to shed light on the importance of flows as a major force affecting foreign exchange (FX) market outcomes. Researchers focused on the funding mechanism for how globally active banks source liquidity when granting loans in another currency such as the US dollar.
When a foreign bank grants a cross-currency US dollar loan, it needs to obtain US dollar liquidity, which puts pressure on funding markets and leads to an appreciation of the US dollar. The researchers focus especially on the aftermath of the 2008–09 financial crisis, which has seen not only a tightening of banking regulation but also structural shifts in US dollar funding markets.
The study finds that flows of cross-currency lending have a substantial and statistically significant effect on exchange rates, particularly in the post-crisis period. They detect a 36 basis point appreciation in the US dollar for a one standard deviation increase in net US dollar lending flows.
Further analysis of the funding mechanisms shows that the effects of flows on exchange rates are stronger when intermediary balance sheets and funding are constrained. Additionally, researchers found that cross-currency lending flows affect key funding markets, such as the FX swap market and the US dollar market for commercial paper and certificates of deposit.