Real Effects of Foreign Exchange Risk Migration: Evidence from Matched Firm-Bank Microdata
Firms that are active in international product and factor markets hedge their exposure to foreign exchange risk by using forward contracts to transfer that risk to banks that are central dealers in the foreign exchange market. This paper identifies this risk migration from firms to the banking sector and the real effects on the German economy in the context of the Brexit referendum in 2016. The authors’ findings show that foreign exchange risk that migrates to the banking sector and is not fully intermediated can have a profound effect on the broader economy. More specifically, imperfect intermediation can result in equity losses at banks, which in turn can lead to a reduction in their credit supply that hampers firms’ ability to borrow and invest and thus triggers a reduction in economic activity.
Key Findings
- In the period between the announcement of the Brexit referendum and the actual vote, firms increased their use of forward contracts with German banks by about 23 percent on average (as measured by the gross notional value of GBP contracts).
- German banks, as counterparties to German firms, increased their supply of GBP forwards in the period before the referendum, but with sizable heterogeneity in their net derivatives position—the difference between short (selling pounds forward) and long (buying pounds forward) positions. This finding suggests that some banks did not fully intermediate the migrated risk; indeed, about 20 percent of the banks had accumulated an exposure of at least 15 percent of their equity value before the referendum date.
- German banks with GBP derivatives exposure incurred losses after the Brexit referendum. For 10 percent of German banks, the loss was larger than 10 percent of their equity value.
- Banks that experienced large losses from their GBP derivatives exposure cut back credit to firms.
- Firms with a strong dependence on banks that suffered derivatives losses experienced an overall cutback in credit after the referendum; they were not able to offset the loss of funding by increasing borrowing from other banks.
- Even firms that did not use derivatives and therefore likely did not have any exposure to foreign exchange risk experienced a credit reduction from German banks facing derivatives losses.
- Nonfinancial firms with strong ex-ante credit relationships with German banks facing losses reduced investment about 2 percentage points more than firms that did not have ties to those banks.
- The adverse effects on credit and investment were concentrated in small firms.
Implications
This paper’s results show that the effects of exchange rate shocks on economic activity are transmitted not only through firms in international product or factor markets, but also through the banking sector. This happens when firms hedge exchange rate risk exposure by using financial derivatives and the banking sector does not fully intermediate the risk to other agents in the economy. Risk migration to the banking sector could amplify systemic shocks, and therefore international macroeconomic models should account for it in order to present a complete picture of the potential effects of exchange rate movements.
Due to its potential effects on financial stability, the migration of foreign exchange risk to the banking sector bears relevance for policymakers designing regulatory foreign exchange risk charges for banks, discussions about the optimal reallocation of foreign exchange risk in the economy, and the conduct of monetary policy, which should consider how foreign exchange exposure could affect economic activity.
Abstract
When firms trade forward contracts with banks to protect foreign currency cash flows against exchange rate movements, foreign exchange risk migrates to the banking sector. We show how this migrated risk may induce systemic repercussions with severe implications for the real economy. For identification, we exploit the Brexit referendum in June 2016 as a quasi-natural experiment in combination with detailed microdata on forward contracts and the credit register in Germany. Before the referendum, firms substantially increased their use of derivatives in response to the heightened uncertainty; banks, in providing these contracts, did not fully intermediate the risk and retained a large share of it on their own books. The depreciation of the British pound in response to the referendum’s outcome posed a shock to the capital of ex ante exposed banks. Banks, especially weakly capitalized ones, absorbed these losses by cutting back credit to all firms, including those unlikely to have had any exchange rate exposure to begin with. Firms that had ex ante borrowing relationships with banks facing losses experienced a larger reduction in credit and a greater decline in investment compared with their industry peers, thereby contributing to the aggregate investment contraction. We also find these effects to be more pronounced for small firms, which is consistent with credit market frictions being rooted in asymmetric information problems.