Uncertainty in the foreign value of the US dollar affects the US banking sector and therefore, the US real economy. In this paper, I propose a novel ‘Exchange Rate (ER) Uncertainty Channel’ and show the effects of increased volatility in the trade-weighted US dollar index on the US banking sector. Higher volatility in the exchange rate leads to retrenchment by foreign banks from the US syndicated loans market (SLM). This entails a loanable funds supply bottleneck for US banks trying to finance their loans through syndicates. US banks respond with tighter credit standards in an attempt to re-allocate scarce funds. In response to a 1 standard deviation increase in ER volatility, US banks’ net interest margin increase by 10 bps annualized, whereas balance sheet contract by 2-3 pp annualized. This is consistent with banks exerting market power in the loan market while simultaneously shrinking their balance sheet. Both the price and volume effects are stronger for US banks with greater exposure to the SLM as measured by their loans-to-interest-earning-assets ratio. Thus, volatility in the US dollar is a ‘global risk indicator’ that significantly affects US banking lending activity.
Sneha Agrawal (Wed,) studied this question.