Banking Leverage Procyclicality: a Theoretical Model Introducing Currency Diversification

The brutal adjustments to global banks' balance sheets in the wake of the recent economic crisis have rekindled interest in the procyclicality of banking leverage. This paper extends Adrian and Shin (2014) by allowing banks to hold assets and liabilities denominated in foreign currency. It investigates the procyclicality of banking leverage relative to the currency diversification of banks' balance sheet. Therefore, it provides a complete theoretical framework that explains heterogeneity in financial cycles when focusing on currency exposures. Our results show that the Value-at-Risk rule followed by banks is still validated when currency diversification is introduced. However, currency diversification changes leverage procyclicality where the decrease or increase in leverage procyclicality relative to the home economy will depend on the type of shock. To the extent that changes in state of nature are asymmetric, currency diversification of assets associated with floating exchange rate regime then increases the risk-taking capacity of banks.