Arbitraging Covered Interest Rate Parity Deviations and Bank Lending

In this paper, I propose and test a new channel that can affect bank lending in an emerging markets setting. This channel works as follows. When there are covered interest rate parity (CIP) deviations, banks attempt to arbitrage them. This requires banks to borrow in a particular currency. In the presence of borrowing frictions, banks either increase the rates paid for deposits to arbitrage or shift a portion of the resources used to lend to fund their arbitrage activities. Either case, bank lending in the currency required to arbitrage decreases. I test this channel by exploiting differences in the abilities of Peruvian banks to arbitrage CIP deviations. I show that banks that have greater ability to arbitrage reduce their lending in the currency they need to fund their CIP arbitrage. This is partly compensated by lending in a different currency. This evidence suggests that arbitraging CIP deviations can affect the currency composition of bank lending