Regulatory Reforms and the Dollar Funding of Global Banks: Evidence from the Impact of Monetary Policy Divergence

Deviations from the covered interest rate parity (CIP), the premium paid to the U.S. dollar (USD) supplier in the foreign exchange swap market, have long attracted the attention of policy makers, since they often accompany a banking crisis. In this paper, we document the emergence of the new drivers of CIP deviations taking the place of banks f creditworthiness and assess their roles. We first provide theoretical evidence to show that monetary policy divergence between the Federal Reserve and other central banks widens CIP deviations, and that regulatory reforms such as stricter leverage ratios raise the sensitivity of CIP deviations to monetary policy divergence by increasing the marginal cost of global banks f USD funding. We then empirically examine whether the data accords with our theory, and find that monetary policy divergence has recently emerged as an important driver that boosts CIP deviation. We also show that regulatory reforms have brought about dual impacts on the global financial system. By increasing the sensitivity of CIP deviations to various shocks, the stricter financial regulations have limited banks f excessive gsearch for yield h activities resulting from monetary policy divergence, and have thereby contributed to financial stability. However, the impact of severely adverse shocks in the asset management sector is amplified by the stricter financial regulations and is transmitted to the FX swap market and beyond, inducing non-U.S. banks to further cut back on their USD-denominated lending.