Banks Underestimate Currency-Trade Loss Risk: Basel Group

Banks underestimate the risk that their trading partners on foreign exchange markets may fail to honor commitments, global regulators said.

Lenders should bolster safeguards against the possibility of currency trades breaking down before they are settled, the Basel Committee on Banking Supervision said in guidance issued today. Banks should set “formal, meaningful” limits on the amount of settlement risk they take on, and restrict the amount of business they do with any single counterparty, the group said in a report on its website.

“Many banks underestimate their principal risk and other associated risks by not taking into full account the duration of exposure between trade execution and final settlement,” the group said. “While such risks may have a relatively low impact during normal market conditions, they may create disproportionately larger concerns during times of market stress.”

Global currency markets handle $4 trillion a day in transactions, according to figures published by the Bank for International Settlements. The market grew by 20 percent between 2007 and 2010, the BIS said. While banks and other institutions active in the currency markets have taken steps to make trading more robust, rapid growth means substantial settlement risks remain, the group said.

The draft rules tackle so-called Herstatt risk, the possibility that a bank can be left facing large losses if it moves first to honor its side of a currency transaction while its trading partner goes bust before fulfilling its obligations. The global financial system was faced with such difficulties when Bankhaus Herstatt failed in 1974, an event that helped persuade regulators to set up the Basel Committee.

The plans update guidance adopted by the Basel group in

2000. The committee said that it would review in 2015 how well banks and regulators apply the rules.