The currency channel of the global bank leverage cycle

The amplitude of leverage procyclicality is heterogeneous across banks and across countries. This paper introduces international diversification of bank balance sheet as a factor of this observed heterogeneity, with a special emphasis on currency diversification. Based on a new theoretical framework, I show that the impact of international diversification on leverage procyclicality depends on the relative performance of economies, the global business cycle and the exchange rate regime. By altering the distribution of global bank portfolio, international diversification adds a currency channel to the risk channel of the global leverage cycle. Using granular data on banks located in France, I show that the pre-crisis international diversification of banks increased leverage procyclicality during the 2008-2009 crisis. Focusing on the currency channel, namely the valuation effect of currency diversification, my results show that it had a negative effect on leverage procyclicality during this period. The currency channel contributed to offset part of the increased risk due to the crisis. These findings draw attention to the specific role of balance sheet currency diversification in financial stability risk