Banks' leverage Procyclicality: Does Currency Diversification Matter?

Currency diversification, which measures how much of assets are denominated in foreign currency, introduces a credit risk diversification and a valuation effect due to fluctuations of exchange rate. It affects banks' leverage responsiveness to the value of assets, namely the leverage procyclicality. Using novel micro data on banks' exposures, we confront theoretical conclusions by focusing on the US dollar diversification of banks located in France between 1999 and 2015. Distinguishing between commercial and investment banks, our analysis first supports previous empirical results where investment banks are more pro-cyclical than commercial banks. Second, our results show that the largest pro-cyclicality of investment banks comes from the effect of currency diversification, especially from the valuation effect of currency diversification which increases procyclicality. Finally, our results confirm the theoretical prediction where a currency mismatch does not strongly affect leverage procyclicality. Our conclusions support the idea that currency diversification is relevant to micro and especially macro-prudential policy.