Bank Dollarization, Lending Behavior and Real Effects

This study investigates how banks' foreign exchange (FX) position affects their lending behavior following an exchange rate shock, and the resulting effects on firms' real economic activities. Utilizing bank-firm level credit registry data along with financial statements of all incorporated firms, we show that banks with higher exposure to FX risk cut their lending and shorten their loan maturities compared to banks with lower exposure. Our further analyses indicate that banks transmit the shock they experience not only to the firms with FX risk but also to the firms with no direct FX risk. Moreover, we find that firms could not avoid the lending contraction by switching to low-exposure banks. This is evident only for SMEs, and not for large firms. We also document real effects, stemming from the banks’ role in propagation of FX shock. Consistent with the contraction in bank lending, SMEs with high-exposure banks exhibited a comparatively negative performance in their net sales, employment, and investment. Our findings underscore the importance of macroprudential policies that monitor and reduce banks’ currency mismatches, thereby mitigating the adverse effects of currency shocks on the real economy. They also highlight the importance of incorporating balance-sheet effects stemming from foreign exchange risk into the conduct of monetary policy.