In light of the internationalization of banking and the more general liberalization of financial markets, together with the increased importance of floating exchange rates, the Basle Committee on Banking Supervision and the European Union took steps recently to harmonize national prudential regulations on foreign exchange risk by applying the capital-adequacy approach already adopted for the 1988 Basle Accord on credit risk. The increasing number of developing countries liberalizing their foreign exchange markets has also led to consideration of quantity restrictions on banks’ capacity to take open foreign exchange positions. This paper explores the theoretical considerations underlying these regulations and restrictions, and evaluates their effectiveness and possible impact on the workings of foreign exchange markets, based on a sample study of 41 developed and developing countries.
The theoretical literature on banking regulation is rather critical of the approach that imposes limits on bank portfolios, whether or not the limits are related to capital. Possible spillovers (or expected external costs) from failures in one jurisdiction to another provide a rationale for coordinating regulations in countries with internationally active banks. However, because it is not established that the Basle approach decreases international systemic risk, optimal coordination could involve considering both the abolition and introduction of capital-adequacy regulations.
This paper suggests that the proposal to amend the 1988 Basle Accord on foreign exchange risk--although potentially improving harmonization of banking regulations--contains several problems. Market risks related to foreign exchange business would not be comprehensively covered, and disincentives would discourage the use of the more market-based method to determine position limits, and thus the exercise of modern portfolio management. These shortcomings stem partly from anticipated adverse effects on exchange rate volatility of the uniform use of the proposed simulation technique, which, in turn, point to a policy dilemma that can arise in attempting to establish prudential foreign exchange risk regulations while managing exchange rates.
In addition, the theoretical literature does clearly indicate whether the capital-adequacy approach is applicable to developing countries. Optimal timing of reform suggests that it might not be advantageous for an incipient foreign exchange market to introduce restricting regulations. Nevertheless, 26 developing countries in the sample collected use foreign exchange position limits, although often for reasons other than prudential regulation. Some limit banks’ long positions more than their short positions in order to alleviate devaluation pressures, clearly contradicting prudential considerations. Moreover, at least one developing country has lowered position limits in order to increase interbank trading activity. The experience of these countries suggests that there is a need--perhaps not limited to developing countries--to distinguish prudential exposure limits from position limits used as capital controls.