The dollar, bank leverage and the deviation from covered interest parity

BIS Working Papers No 592
November 2016

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.

JEL classification: F3, G1, G2

Keywords: exchange rates, bank leverage, cross-currency basis