Supervision of banks' foreign exchange positions
There are many activities of banks which involve risk-taking, but there are few in which a bank may so quickly incur large losses as in foreign exchange transactions. The risks inherent in foreign exchange business, particularly in running open foreign exchange positions, have been heightened in recent years by the increased instability of exchange rates. Consequently, the monitoring of these risks has become a matter of increased interest to supervisory authorities.
The purpose of this note is to consider the prudential aspects of banks' foreign exchange activities. It is not directly concerned with the restrictions that countries may place on their banks' foreign exchange business for exchange control, monetary or other macro-economic reasons. In exercising prudential control over this area of banks' activities, however, supervisory authorities need to take into account the role of the banks as "market-makers" in foreign exchange. This role has two aspects. Firstly, banks have to quote rates to their customers (including other banks) at which they stand ready to buy and sell currencies. Secondly, by themselves taking open positions in currencies, banks (as well as non-banks) help to ensure that the foreign exchange markets are balanced at any point of time without excessive and erratic exchange rate fluctuations. In other words, supervisors have to weigh prudential considerations against the need to enable the banks to play their part in the smooth and efficient functioning of the exchange markets. Whatever may be the exact balance struck between these considerations, supervisory authorities must seek to ensure that the risks assumed by banks in their foreign exchange operations are never so large as to constitute a significant threat either to the solvency and liquidity of individual banks, or to the health and stability of the banking system as a whole.