Bank Cost Efficiency and Credit Market Structure Under a Volatile Exchange Rate

We study the differential impact of exchange rate volatility on cost efficiency and market structure when banks have non-trivial exposures to foreign currency operations. We use unique pre-war data on quarterly revaluations of assets and liabilities denominated in foreign currencies that Russian banks were reporting between 2004Q1 and 2020Q2. First, we document that cost efficiency estimates are both severely downward biased---by 30 percentage points on average---and generally not rank preserving when these quarterly revaluations are ignored. However, using nonparametric copulas, we also reveal an extreme tail dependence in the bank cost efficiency rankings constructed with the revaluations being kept or dropped. We relate this phenomenon to the observed variation in the banks' ability to predict future movements in the nominal exchange rate. Second, we show that the revaluations are positively associated with (corporate) bank lending. We then find that keeping the revaluations when estimating bank cost efficiency leads to a misleading conclusion that the credit market is inefficient; we show that this is driven by the upper quartile of the banks' distribution by total assets. Third, to ensure generalizability to other emerging market economies (EMEs), we suggest a two-stage approach that does not rely on our unique data on revaluations but rather employs banks' exposures to foreign currencies and aggregate exchange rate volatility. With this approach, we can close the downward bias in efficiency estimates by 2/3rds and still establish that the (dollarized) credit market is efficient