Basel Committee issues guidance on FX settlement risk

The Basel Committee on Banking Supervision today issued a revised version of its guidance for supervisors on managing the settlement risk arising from foreign exchange transactions.

The guidance stresses that foreign exchange settlement risk is a form of credit risk that banks should manage, like other credit risks of a similar size and duration, through a formal process of measurement and control with active senior management oversight. It also suggests that supervisors should focus on whether a bank has evaluated potential FX settlement risk reductions from netting and other private sector initiatives.

The revised guidance takes account of comments received on the consultative draft issued in July 1999. It was drawn up in close consultation with the Committee on Payment and Settlement Systems and builds on the work of that Committee, in particular its reports Settlement Risk in Foreign Exchange Transactions (March 1996) and Reducing Foreign Exchange Settlement Risk: A Progress Report (July 1998).

Mr Roger Cole, Chairman of the Basel Committee's Risk Management Group, noted: "For many banks, foreign exchange transactions are the biggest source of settlement risk - and the amounts can be very large. It is therefore important that supervisors determine that banks manage this risk appropriately. Although implementing proper risk management policies can be a major task for a bank, all banks should by now have a good understanding of FX settlement risk and have formulated clear and firm plans for how to manage it, even if those plans have not yet always been fully implemented".

Most of the revisions made to the guidance since the July 1999 draft are attempts to clarify the text. In particular, there is more emphasis on the nature of FX settlement risk as a form of credit risk and an expanded discussion on what is involved in measuring and limiting the risk. There is also fuller recognition of the potential risk-reducing importance of alternatives to traditional trade by trade settlement, including netting and the CLS Bank, once established.

In this connection, Mr William J McDonough, Chairman of the Basel Committee, stated: "This guidance reinforces the stance of the G10 Governors that FX settlement risk must be substantially addressed by the private sector. Banking supervisors need to ensure that individual banks are taking all appropriate steps to measure, manage, and control this risk. In particular, the guidance makes it clear that banks have an obligation to thoroughly explore and take advantage of the benefits offered by industry-sponsored risk-reduction initiatives".