Bank foreign currency funding and currency markets: the case of Mexico post GFC

Abstract

Foreign exchange funding in the banking sector is a key financial stability concern. The paper examines the role of foreign currency hedging demand in the foreign exchange market, the key market where banks manage business model driven currency mismatch. First, the paper documents substantial and persistent deviations from covered interest parity for Mexico. Next, granular data from regulatory filings on derivatives transactions and bank balance sheets are used to assess the impact of two variables: 1. the FX funding gap of domestic bank balance sheets and 2. external foreign currency hedging demand. The two currency hedging demand measures are each included in an econometric model of covered interest parity (under limits to arbitrage) with tenures from 1 month to 12 months, and then interacted with arbitrageur balance sheet constraint variables to test whether these amplify the impact of hedging demand. The main result of the paper is that both hedging variables directly influenced CIP deviations in Mexico, while interaction effects varied across hedging measures. The direct effect was robust to including relative arbitrage funding costs, and foreign exchange bid/ask spreads in the regression model. These results from the Mexican case suggest hedging demand can be a more significant factor in foreign exchange forward markets than has so far been documented, and an important factor even at shorter maturities and in an emerging economy's financial markets. One implication is that Mexican domestic banks' abilities to manage currency mismatch is influenced by external hedging demand. This paper adds to the literature on CIP deviations after the Global Financial Crisis by analyzing the case of an emerging market, with the unique advantage of using regulatory filings data and actual FX derivatives transactions data.