The Dollar, Bank Leverage and the Deviation from Covered Interest Parity

We document the triangular relationship formed by the strength of the US dollar, cross-border bank lending in dollars and deviations from covered interest parity (CIP). A stronger dollar goes hand-in-hand with bigger deviations from CIP and contractions of cross-border bank lending in dollars. Differential sensitivity of CIP deviations to the strength of the dollar can explain cross-sectional variations in CIP arbitrage profits. We argue that underpinning the triangle is the role of the dollar as proxy for the shadow price of bank leverage