We examine a critical case of regulatory arbitrage in the Brazilian banking sector, where a tax asymmetry created incentives for overhedging foreign currency risk. We demonstrate how this tax distortion, which exempted foreign investments from taxation while taxing the financial hedge, led banks to take on excessive hedge positions. The overhedge is a form of carry trade. Therefore, it influenced foreign exchange (FX) market dynamics and posed a significant challenge to financial stability. Our empirical analysis reveals that banks exploited this regulatory loophole to generate near-risk-free profits, contributing to heightened systemic risk. To explore the broader macroeconomic consequences, we develop a twocountry, open-economy model that integrates financial frictions and the observed tax distortion. The model shows that such overhedging activities amplify macroeconomic volatility, intensify the impact of financial shocks, and worsen exchange rate depreciations during crises.
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