The Bank for International Settlement has issued fresh guidance on the management of foreign exchange settlement risk, amid concerns that bank back offices are being overwhelmed by massive growth in FX dealing volumes.
The new guidance is the first issued by the central banks bank since 2000 and offers more comprehensive and detailed direction on governance arrangements and the management of principal risk, replacement cost risk and all other FX settlement-related risks.
The lag in the settlement of FX transactions has long been a concern of banking supervisors and central banks. The failure of Bankhaus Herstatt in 1974 highlighted the ripple effect of counterparty failure as a source of potential systemic disruption to currency market players.
While much progress has been made in curbing associated FX settlement risk over the past decade, particularly through the use of netting and payment-versus-payment arrangements, regulators fear that many banks do not have a good understanding of the potential residual risks, including replacement costs and liquidity risks.
"The banks' methods of identifying, measuring, monitoring and controlling FX settlement-related risks are not always acceptably robust," says the BIS. "Moreover, growth in the size of the FX market since 2000 suggests that the absolute value settled by potentially riskier gross non-PVP methods may not be less than before PVP methods existed."
The updated guidance is organised into seven "guidelines" that address governance, principal risk, replacement cost risk, liquidity risk, operational risk, legal risk and capital for FX transactions.
In the back office, the BIS asserts that a bank should have "sufficiently robust" systems to capture, measure and report on FX settlement-related exposures on a bank-wide basis, across business lines and counterparties.
The sophistication of systems should reflect the risk profile and complexity of the bank, and should include detailed reporting and fails management systems.
"Timely reports should be provided to the bank's board and senior management and include appropriate key risk indicators and risk issues that could result in a potential loss," says the BIS. "A bank should ensure that its framework identifies FX fails and captures the full amount of the resulting FX settlement-related risks as soon as practicable, to allow senior management to make appropriate judgements regarding the nature and severity of the exposure."
The full document has been released for consultation, with the Bank setting a mid-October deadline for submissions.
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