FX Intervention, Prudential Bank Regulation and Taxes: The case of Brazilian Banks’ Overhedge

Advisor: Márcio Garcia

This study investigates the phenomenon of overhedge by Brazilian banks — an incentive to hold excessive hedge positions, since changes in the value of foreign investments due to exchange rate fluctuations were not taxed, unlike the associated hedging strategies. We examine how this behavior interacts with foreign exchange (FX) interventions, macroprudential bank regulation, and taxation. Our empirical evidence suggests that Brazilian banks exploited this overhedging mechanism to secure near-risk-free profits, thereby influencing FX market dynamics. To analyze the macroeconomic implications, we develop a two-country open economy dynamic general equilibrium model incorporating financial sector frictions and tax distortions. Our findings indicate that overhedging amplifies macroeconomic volatility, intensifies the effects of financial constraint shocks, and exacerbates exchange rate depreciations during crises. Furthermore, we show that FX interventions can mitigate these adverse effects by stabilizing the exchange rate and reducing welfare losses. These findings highlight the unintended consequences of tax asymmetries and offer policy insights into the effectiveness of FX interventions and prudential regulations in enhancing financial stability.