Question

An African country has a policy of fixing the exchange rate value of its currency to the U.S. dollar. Banks in the country have a business model in which the banks pay competitive interest rates to attract U.S. dollar deposits, and the banks then use these funds to make higher-interest loans denominated in the local currency. How likely would an unexpected devaluation of the local currency be to lead to banking crisis? Why?

Answer 1

A devaluation of local currency reduces the value of the local currency against a foreign currency (in this case, USD). Now, while the money that the bank has to pay back to the depositers in terms of USD does not change (when they withdraw deposits and since deposits are liablities to banks), the amount that the banks have to pay back in terms of the local currency increases because more local money is needed to amount to the same amount of USD (due to devaluation).

The repayments of the loans denominated in local currency is at the expected level in terms of local currency. However, if calculated in terms of USD, the repayment value is reduced due to the reduced value of the local currency.

Therefore, the liabilities of the banks in terms of local currency increases, while its assets (the loans denominated in local currency) remain the same in terms of local currency. Or in terms of USD, while the withdrawal value (liabilities) remain the same, the asset value (loans in local currency) decreases due to devaluation. Therefore, there is a significant asset-liability mismatch leading to a banking crisis.