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Currency Diversification of Banks: A Spontaneous Buffer Against Financial Losses

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Abstract
The Basel Committee on Banking Supervision has introduced in December 2010 a Basel III framework for more resilient banks and banking system. We posit in this paper that, in addition to the current regulatory instruments currently under the review of authorities, the currency diversification of banks’ balance sheets can be a source of banking stability considering both assets and liabilities simultaneously. Our conclusions are based on a simplified definition of a globalized bank’s balance sheet. As banks’ balance sheets are expressed in domestic currency, our model implies an exchange rate conversion of each foreign component. Risks are introduced with stochastic processes in assets, liabilities and exchange rate. In accordance with the Basel III framework and the Basel III Leverage ratio, the bank’s leverage ratio is limited. Our model provides detailed information in each risk faced by global banks including foreign exchange risk. Although our conclusions depend on the variance covariance matrix of assets, liabilities and foreign exchange rate, our main results confirm the positive impact of currency diversification on banking stability considering the current banking system.

Suggested Citation

  • Justine Pedrono, 2016. "Currency Diversification of Banks: A Spontaneous Buffer Against Financial Losses," AMSE Working Papers 1611, Aix-Marseille School of Economics, France.
    • Handle: RePEc:aim:wpaimx:1611
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    References listed on IDEAS

    as
    1. Douglas W. Diamond & Raghuram G. Rajan, 2000. "A Theory of Bank Capital," Journal of Finance, American Finance Association, vol. 55(6), pages 2431-2465, December.
    2. Justine Pedrono, 2015. "Banking Leverage Procyclicality: A Theoretical Model Introducing Currency Diversification," Working Papers halshs-01203758, HAL.
    3. Chuck C Y Kwok & David M Reeb, 2000. "Internationalization and Firm Risk: An Upstream-Downstream Hypothesis," Journal of International Business Studies, Palgrave Macmillan;Academy of International Business, vol. 31(4), pages 611-629, December.
    4. Driessen, Joost & Laeven, Luc, 2007. "International portfolio diversification benefits: Cross-country evidence from a local perspective," Journal of Banking & Finance, Elsevier, vol. 31(6), pages 1693-1712, June.
    5. Justine Pedrono & Aurélien Violon, 2016. "Banks' Capital Structure and US Dollar Diversification of Assets: Does Reduction in Systemic Risk Offset Agency Costs?," AMSE Working Papers 1610, Aix-Marseille School of Economics, France.
    6. David M Reeb & Chuck C Y Kwok & H Young Baek, 1998. "Systematic Risk of the Multinational Corporation," Journal of International Business Studies, Palgrave Macmillan;Academy of International Business, vol. 29(2), pages 263-279, June.
    7. Justine Pedrono & Aurélien Violon, 2016. "Banks' Leverage Procyclicality: Does US Dollar Diversification Really Matter?," Working Papers halshs-01216658, HAL.
    8. Levy, Haim & Sarnat, Marshall, 1970. "International Diversification of Investment Portfolios," American Economic Review, American Economic Association, vol. 60(4), pages 668-675, September.
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    More about this item

    Keywords

    Basel III; Bank; Financial integration; Financial Stability; Currency ; Diversification; Financial Volatility.;
    All these keywords.

    JEL classification:

    • F01 - International Economics - - General - - - Global Outlook
    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • F6 - International Economics - - Economic Impacts of Globalization
    • G01 - Financial Economics - - General - - - Financial Crises
    • G1 - Financial Economics - - General Financial Markets
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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