Granular banking flows and exchange-rate dynamics

Staff working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 22 September 2023

Staff Working Paper No. 1,043

By Balduin Bippus, Simon Lloyd and Daniel Ostry

Using data on the external assets and liabilities of global banks based in the UK, the world’s largest centre for international banking, we identify exogenous cross-border banking flows by constructing novel granular instrumental variables. In line with the predictions of a new granular international banking model, we show empirically that cross-border flows have a significant causal impact on exchange rates. A 1% increase in UK-based global banks’ net external US dollar-debt position appreciates the dollar by 2% against sterling. While we estimate that the supply of dollars from abroad is price-elastic, our results suggest that UK‑resident global banks’ demand for dollars is price-inelastic. Furthermore, we show that the causal effect of banking flows on exchange rates is state dependent, with effects twice as large when banks’ capital ratios are one standard deviation below average. Our findings showcase the importance of banks’ risk-bearing capacity for exchange-rate dynamics and, therefore, for insulating their domestic economies from global financial shocks.

Granular banking flows and exchange-rate dynamics

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