Is Your Bank Hiding a Secret? How Exchange Rates Can Skew the Picture
"Uncover the hidden costs and surprising inefficiencies lurking in the global banking sector due to volatile exchange rates."
In today's interconnected world, banks often engage in foreign currency operations, yet emerging market economies (EMEs) have seen a surge in foreign currency-denominated debt. While financial institutions attempt to balance their assets and liabilities using various hedging strategies, currency mismatches continue to grow, particularly in emerging markets. These imbalances can lead to substantial losses when exchange rates fluctuate.
While existing research highlights the impact of currency crises on bank stability and economic downturns, less attention has been paid to how exchange rate volatility affects bank performance and credit market structures. When local currencies depreciate, banks incur additional costs related to revaluating international and domestic liabilities, which can distort perceptions of their efficiency.
This article explores how currency revaluations can obscure the assessment of bank performance, shedding light on the underlying drivers and broader implications for credit market efficiency and financial stability.
The Hidden Costs of Currency Revaluations: Why Ignoring Them Matters
A recent study examined the banking sector in Russia between 2004 and 2020, a period marked by significant exchange rate volatility and economic shifts. The researchers chose Russia for four key reasons: its status as an emerging market highly dependent on natural resource exports; its substantial credit expansion; the high volatility of the Russian Ruble, especially after it was floated in 2013; and the unique availability of data on quarterly revaluations of foreign currency assets and liabilities.
- Downward Bias: Cost efficiency estimates are typically underestimated by an average of 30% when revaluations are not considered.
- Distorted Rankings: Excluding revaluations can lead to inaccurate rankings of bank efficiency, except for the most and least efficient banks.
- Two-Stage Approach: To address this, the study suggests a two-stage approach that doesn't rely on revaluations but still reduces the bias in cost efficiency estimates.
- Drivers of Revaluations: Revaluations are triggered by mismatches in banks' foreign currency operations, influenced by household foreign currency deposits and the instability of the Ruble's exchange rate.
- Credit Market Inefficiency: Failure to account for revaluations can lead to the mistaken conclusion that the credit market is inefficient, particularly among larger banks.
The Path Forward: Adapting to Currency Volatility
Understanding and accounting for the impact of exchange rate fluctuations on bank performance is crucial for maintaining financial stability. By recognizing the hidden costs associated with currency revaluations, policymakers and financial institutions can make more informed decisions, leading to a more accurate and resilient banking sector.