Banks’ Leverage in Foreign Exchange Derivatives in Times of Crises: A Tale of Two Countries

Abstract

Before the outbreak of the Global Financial Crisis, on May 6, 2007, the Colombian central bank imposed a cap on the Gross Leverage Position in Foreign Exchange Derivatives of financial intermediaries. It was the only country in the world in implementing this prudential policy. By leveraging insights from synthetic control literature we construct counterfactual scenarios and show that this policy intervention, while costly in financial stability terms in the pre-GFC period, was effective in reducing Colombia’s financial stability risks during the crisis. A trade-off between “calm” and “turbulent” periods emerges from our results, which should be taken into account when deciding on the right policy tools to use before a crisis breaks out.