Basle Committee on Banking Supervision, 1996, Amendment to the Capital Accord to Incorporate Market Risks (Basle: Bank for International Settlements).
Basle Committee on Banking Supervision, 1992, Minimum Standards for the Supervision of International Banking Groups and their Cross-Border Establishments (Basle: Bank for International Settlements).
Basle Committee on Banking Supervision, 1988, International Convergence of Capital Measurement and Capital Standards (Basle: Bank for International Settlements).
Basle Committee on Banking Supervision, 1983, Principles for the Supervision of Banks′ Foreign Establishments (Basle: Bank for International Settlements).
Basle Committee on Banking Supervision, 1980, Supervision of Banks’ Foreign Exchange Positions (Basle: Bank for International Settlements).
BIS, 1996, Committee on Payment and Settlement Systems, prepared by the Settlement Risk in Foreign Exchange Transactions of the central banks of the Group of Ten Countries.
Boothe, Paul, and Debra Glassman, “The Statistical Distribution of Exchange Rates: Empirical Evidence and Economic Implications,” Journal of International Economics. (22), May 1997.
European Union, Council Directive 93/6/EEC of 15 March 1993 on “The Capital Adequacy of Investment Firms and Credit Institutions,” Luxembourg: Office of Official Publications of the European Communities.
Folkerts-Landau, David, and Carl-Johan Lindgren, 1998, Toward a Framework for Financial Stability, World Economic and Financial Surveys (Washington: International Monetary Fund).
Hartmann, Philipp, 1995, “Capital Adequacy and Foreign Exchange Risk Regulation: Recent Developments in Industrial Countries, Special Paper No. LXXVII, December 1995, (London: London School of Economics Financial Markets Group).
Jackson, Patricia, 1995, “Risk Measurement and Capital Requirements for Banks,” Quarterly Bulletin, 35 (2), pp. 177-184 (London: Bank of England)
Johnson, Norman Lloyd and Samuel Kotz, 1971, Distribution in Statistics: Continuous Univariate Distribution (New York: John Wiley and Sons).
Leahy, Michael P., 1991, “Determining Foreign Exchange Risk and Bank Capital Requirements.” International Finance Discussion Paper, No 400, (Washington: Board of Governors of the Federal Reserve System).
The authors would like to thank Olivier Frécaut, Peter Hayward, John Leimone, Carl-Johan Lindgren, Tom Nordman, and Inci Otker for helpful discussion, comments, and suggestions, and Natalie Baumer for her editorial assistance. Mr. Abrams is Deputy Chief in the Banking Supervision and Regulation Division. Ms. Beato was a consultant in the Banking Supervision and Regulation Division when the paper was originally drafted, and she is now Principal Economist in the Infrastructure and Financial Markets Division of the Inter-American Development Bank.
Market risk may be defined as “the risk of losses in on- and off-balance sheet positions arising from movements in market prices.” Basle Committee on Banking Supervision (Basle Committee, 1996), p.l. Exchange risk may be defined as “the risk that a bank may suffer losses as a result of adverse movement during a period in which it has an open position, either spot or forward, or a combination of the two in an individual foreign currency.” Basle Committee (1980), p. 1.
Certain risks related to foreign exchange operations are not covered in this paper, including inter alia, risk of losses when only one leg of a foreign exchange transaction is settled (called Herstatt risk). For a discussion of foreign exchange settlement risks associated with foreign exchange transactions, see Bank for International Settlement (1996).
Although this paper focuses on more supervisors’ efforts to regulate banks’ foreign exchange risk, best practices of bankers and supervisors should be essentially the same. The difference is that while a prudent banker seeks to maximize the value of the bank, a supervisor seeks to maintain an efficient banking system, and avoid the systemic difficulties associated with multiple banks failures.
Increasingly deep and efficient markets also allow a trader to take a position more quickly, so conventional reporting requirements and examination procedures that rely on limits and capital charges are less effective than they once were.
As used in this paper, the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. In particular, as used here, the term “country” also may cover Hong Kong Special Administrative Region.
A variety of rules are used regarding the recording of fixed assets located abroad, but they are usually recorded in the currency of the country in which these assets are located.
However, the current spot rate is normally used for internal risk management operations if the institution trades on an ongoing basis.
Basle Committee (1996), p. 23. The proposal also includes a discussion of managing the risks associated with foreign exchange options, but this is beyond the scope of this paper.
If a bank has positions in groups of currencies whose movements are highly correlated, for example, in EMS currencies for a non-EMS country, it may be preferable to aggregate positions in those currencies and use the gross aggregate or shorthand method, rather than use those holdings as a reason for using the net aggregate position.
For a useful discussion of VAR models, as well as Basle Committee proposals regarding the use of these models, see IMF (1995), pp. 141—147.
Problems may also arise because both of these distributions allow a non-zero probability of the exchange rate turning negative unless, as Johnson and Kotz (1971) suggest, natural logarithms are used.
Imposing the supervisor’s model on the banks would also require that the supervisor accept the moral—and perhaps legal—responsibility for any extraordinary losses arising, should market developments diverge significantly from the parameters of the model. Such an arrangement might also encourage a bank to take risks which, while excessive based on its own model, are within the limits of the supervisor’s model, on the belief that should serious losses arise, the bank may seek restitution from the supervisor on the grounds that the supervisor’s model encouraged it to engage in excessive risk taking.
The model also does not have to face problems with nonlinearities, such as those associated with options contracts, which can undermine VC models.
In high inflation countries with low bank profitability, banks may also wish to hold a structural foreign currency position to hedge their capital against inflation.
Thus, structural positions would also include foreign assets that the regulator allows to be recorded at historical cost. Hence a bank may have a notional structural position rather than holding excess assets explicitly in foreign currency as reflected in its balance sheet.
The principle of consolidated supervision of banks was laid out in the Basle Committee’s Concordat in 1983, which has subsequently been amended several times, see Basle Committee (1983 and 1992, respectively).
Basle Committee (1980) contains a succinct discussion of the role of bank management in ensuring the safety of a bank’s foreign exchange operations.
Procedures for recording and converting foreign currency assets and liabilities are discussed in II.A.
Some modern internal control systems assign primary responsibility for designing and implementing internal controls to line officers, while internal audit tests that proper controls are in place, and makes spot checks to ensure that they are implemented effectively. In the case of foreign exchange trading, compliance is enforced through the back office, which reports to either a senior manager or committee charged with compliance; not unlike the traditional audit function.
A parallel example is with credit risk, where most supervisors place a single limit on large exposures, independent of the borrower (other than government).
Some countries also set differential limits set on their banks’ overall long and overall short foreign exchange positions. Asymmetric limits would only seem appropriate when the risks are asymmetric. Otherwise, one must question whether the limit is being imposed solely for prudential purposes, or whether it is also being used as a capital control. Similar questions may arise when a country frequently adjusts its foreign exchange exposure limits, particularly if the changes are not in response to changes in either the capital positions of the banks or perceived improvements in banks’ ability to manage foreign exchange risk.
National supervisors may also exempt a bank from capital requirements on its foreign exchange positions, if its gross aggregate position does not exceed 100 percent of capital, and its net aggregate position is less than 2 percent of capital. Basle Committee (1996), p. 26.
The position also includes the bank’s open position in gold.
The use of a multiplication factor greater than one may reflect uncertainties associated with the limited experience in the use of VAR models as a supervisory tool.
Tier 3 capital consists of unsecured, subordinated debt, with an original maturity of at least two years, and may not be repaid before the agreed repayment date without the approval of the supervisor. It must also have a lock-in clause stipulating that neither interest nor principal may be paid (even at maturity), if such payments would cause the institution to fall below, or remain below, its minimum capital requirements.
Tier 2 capital may also be substituted for Tier 3 capital, up to the same 250 percent limit. However, some Committee member countries will continue to require that at least half of all bank capital be primary capital, that is, Tier 1. Basle Committee (1996), p. 7.
Unless, of course, all or virtually all exposures are in a single currency.
Such as that experienced in several Asian countries in 1997.