Currency Diversification of Banks: A Spontaneous Buffer Against Financial Losses

The Basel Committee on Banking Supervision has introduced in December 2010 a Basel III framework for more resilient banks and banking system. We posit in this paper that, in addition to the current regulatory instruments currently under the review of authorities, the currency diversification of banks’ balance sheets can be a source of banking stability considering both assets and liabilities simultaneously. Our conclusions are based on a simplified definition of a globalized bank’s balance sheet. As banks’ balance sheets are expressed in domestic currency, our model implies an exchange rate conversion of each foreign component. Risks are introduced with stochastic processes in assets, liabilities and exchange rate. In accordance with the Basel III framework and the Basel III Leverage ratio, the bank’s leverage ratio is limited. Our model provides detailed information in each risk faced by global banks including foreign exchange risk. Although our conclusions depend on the variance covariance matrix of assets, liabilities and foreign exchange rate, our main results confirm the positive impact of currency diversification on banking stability considering the current banking system.