Bank Cost Efficiency and Credit Market Structure Under a Volatile Exchange Rate

TL;DR

This paper investigates how exchange rate volatility impacts bank cost efficiency and market structure, revealing that foreign currency revaluations significantly influence costs and can distort efficiency assessments, with implications for financial stability.

Contribution

It introduces a novel two-stage approach to estimate bank cost efficiency that accounts for FX revaluations, reducing bias and improving accuracy in emerging markets.

Findings

Revals account for 26.5% of total bank costs on average.

Ignoring Revals biases efficiency estimates downward by 30%.

Revals are driven by household FX deposits and Ruble instability.

Abstract

We study the impact of exchange rate volatility on cost efficiency and market structure in a cross-section of banks that have non-trivial exposures to foreign currency (FX) operations. We use unique data on quarterly revaluations of FX assets and liabilities (Revals) that Russian banks were reporting between 2004 Q1 and 2020 Q2. {\it First}, we document that Revals constitute the largest part of the banks' total costs, 26.5\% on average, with considerable variation across banks. {\it Second}, we find that stochastic estimates of cost efficiency are both severely downward biased -- by 30\% on average -- and generally not rank preserving when Revals are ignored, except for the tails, as our nonparametric copulas reveal. To ensure generalizability to other emerging market economies, we suggest a two-stage approach that does not rely on Revals but is able to shrink the downward bias in cost efficiency estimates by two-thirds. {\it Third}, we show that Revals are triggered by the mismatch in the banks' FX operations, which, in turn, is driven by household FX deposits and the instability of Ruble's exchange rate. {\it Fourth}, we find that the failure to account for Revals leads to the erroneous conclusion that the credit market is inefficient, which is driven by the upper quartile of the banks' distribution by total assets. Revals have considerable negative implications for financial stability which can be attenuated by the cross-border diversification of bank assets.