Systemic Risk in Europe Due to Foreign Currency Loans

Abstract

Foreign currency loans given to the unhedged non-bank sector are remarkably prevalent in Europe. Especially Swiss franc denominated loans, which are widely popular in Eastern European countries, are believed to pose a significant exchange-rate-induced credit risk to the European banking sectors. A sudden depreciation of the domestic currencies in Eastern European countries could trigger simultaneous bank failures, if unhedged borrowers cannot service their foreign currency loans anymore. Therefore they pose a systemic risk from a “common market shock” view. This paper attempts to quantify the systemic risk arising from foreign currency loans in 17 European countries quarterly between 2007:Q1 and 2011:Q3. For that purpose, I use a novel dataset collected by the Swiss National Bank and I build on the method suggested in Ranciere, Tornell, and Vamvakidis (2010). In particular, I calculate to which extent the European banking sectors’ balance sheets would be affected if households and/or non-financial firms cannot pay back their foreign currency loans. I find that the systemic risk in Eastern Europe is substantial, while it is relatively low in the remaining European countries. However, CHF-denominated loans are not the main source behind the systemic risk in Eastern Europe, contrary to what the policymakers and the general public might perceive. I find that loans denominated in other foreign currencies (possibly in euros) contribute to the systemic risk in Eastern Europe significantly more than CHF loans do. Furthermore, systemic risk shows high persistence, and low volatility during the sample period. Last but not least, banks in Europe have been persistently holding more foreign currency denominated assets than liabilities, indicating that they are aware of the exchange-rate-induced credit risk they are facing.