Banking Leverage Procyclicality: A Theoretical Model Introducing Currency Diversification

The brutal adjustments to global banks’ balance sheets in the wake of the recent economic crisis have rekindled interest in the procyclicality of banking leverage. During economic bursts, the collateral value of banks decreases and their risk-taking capacity is reduced. Banks raise less funds and their leverage - defined as total assets over equity - goes down: the leverage is procyclical. The paper investigates the procyclicality of bank leverage when banks can borrow and invest in two different currencies, as with European banks. To the extent that shocks are asymmetric, we find that currency diversification of assets reduces the procyclicality of the leverage and that a floating exchange rate increases the risk-taking capacity of banks