The Information Content in Bank Currency Mismatches in Fixed Exchange Rate Regimes

Banks tend to leave their currency exposures uncovered in fixed and “intermediate” exchange rate regimes. The paper asks why this is the case. There are three possible explanations: First, hedges are costly and the currency peg is credible; Second, financial markets are incomplete and so hedging instruments are unavailable; or third, hedges are costly and banks expect a bailout should currency gyrations threaten their solvency. The paper demonstrates that the third argument is not time consistent and therefore that uncovered currency exposures reflect currency peg credibility or financial incompleteness and not moral-hazard risk taking. 1. Introduction Many Southeast Asian countries suffered currency and banking crises during the 1990s: Thailand, Indonesia, and Malaysia are just a few very notable examples of that period’s twin crises. While their banking sectors were already fragile before the currency crises of 1997, their massive devaluations further weakened many banks that had failed to hedge their foreign exchange exposures. (Indeed, Burnside et al. [1], argue that banking fragilities and expected bailouts contributed to their currency crises). The tendency to leave currency positions uncovered is not unique to Southeast Asia. As McKinnon and Pill [2] and Burnside et al. [3] have remarked, banks in countries with currency pegs tend to leave their currency exposures opened. (It is interesting that Arteta [4] demonstrates that an increase in exchange rate flexibility is associated with an increase of bank currency mismatches in transition and developing countries as those regimes encourage dollarization). The present paper asks why this is the case and investigates the information content in bank currency exposures in fixed exchange rate regimes. There are several reasons why banks may fail to close their foreign exchange positions in fixed exchange rate regimes. first, countries with immature and incomplete financial markets also tend to be those that adopt currency pegs. Thus banks in such countries must absorb liquidity internationally in order to finance their domestic loan operations. (Eichengreen et al. [5] coined the phrase “original sin” to refer to this tendency to borrow abroad in foreign currencies). The incomplete nature of their financial markets means that hedging instruments simply are not available and results in currency mismatches. However, even if markets are complete and hedging instruments are available, banks may still leave their positions uncovered: if hedges are costly and the currency peg is credible, then banks may not