FRBSF Economic Letter
1996-27 | September 20, 1996
Have the big U.S. bank holding companies exposed themselves to excessive foreign exchange risk? Has their use of foreign exchange contracts contributed to their exposure? And what about the big Japanese banks — are they similarly exposed? In the wake of new international agreements to regulate the banks’ risks, these questions have become increasingly important. This Economic Letter addresses these questions by considering the sources of foreign exchange exposure and the appropriate methods for measuring it. Drawing on the results of a formal study of these issues, it concludes that U.S. and Japanese banking institutions, by and large, have insulated themselves against excessive foreign exchange risk.
Foreign exchange rate fluctuations affect banks both directly and indirectly. The direct effect comes from banks’ holdings of assets (or liabilities) with net payment streams denominated in a foreign currency. Foreign exchange rate fluctuations alter the domestic currency values of such assets. This explicit source of foreign exchange risk is the easiest to identify, and it is the most easily hedged.
The indirect sources of risk are more subtle but just as important. A bank without foreign assets or liabilities can be exposed to currency risk because the exchange rate can affect the profitability of its domestic banking operations. For example, consider the value of a bank’s loan to a U.S. exporter. An appreciation of the dollar might make it more difficult for the U.S. exporter to compete against foreign firms. If the appreciation thereby diminishes the exporter’s profitability, it also diminishes the probability of timely loan repayment and, correspondingly, the profitability of the bank. In this case, the bank is exposed to foreign exchange risk: a stronger dollar decreases its profitability. In essence, the bank is “short” dollars against foreign currency. Any time the value of the exchange rate is linked to foreign competition, to the demand for loans, or to other aspects of banking conditions, it will affect even “domestic” banks.
Foreign exchange risk also may be linked to other types of market risk, such as interest rate risk. Interest rates and exchange rates often move simultaneously. So, a bank’s interest rate position indirectly affects its overall foreign exchange exposure. The foreign exchange rate sensitivity of a bank with an open interest rate position typically will differ from that of a bank with no interest rate exposure, even if the two banks have the same actual holdings of assets denominated in foreign currencies. Again, the vulnerability of the bank as a whole to foreign exchange fluctuations depends on more than just its holdings of foreign exchange.
The direct sources of foreign exchange risk can be gauged by tallying up the net positions on a bank’s assets and liabilities that are denominated in foreign currencies. By itself, this gauge of direct exposure can provide only a narrow assessment of the bank’s exchange rate sensitivity since — as described above — the value of the bank’s domestic assets also will vary with the exchange rate. Narrow as it is, this gauge provides the “standardized method” for assessing a bank’s overall foreign exchange exposure; specifically, under the aegis of the Basel Committee on Banking Supervision, central bankers from Europe, Japan, and North America proposed in 1993 the use of such methods in assessing the exposure to a variety of market risks, including foreign exchange risk.
The example of the bank’s loan to the exporter shows the limitations of the narrow, standardized method most clearly. While the exporter’s loan by itself leaves the bank short in dollars, the standardized method captures none of this indirect exposure. Further, if the bank were to use the foreign currency market to hedge the short dollar position, then the standardized method, having missed the original exposure, would mistakenly treat the hedge as if it added to exposure. In general, if a bank chooses its foreign exchange holdings to offset open positions arising from its other activities, then its holdings serve to reduce its overall foreign exchange risk. Under such circumstances, treating the bank’s foreign exchange holdings as though they contribute to risk — as the standardized approach does — is inappropriate.
Responding in part to such limitations, the Basle Committee ultimately allowed for a more flexible approach to evaluating foreign exchange and other market risks (Basle Committee 1996). By 1997, bank regulators in all of the represented countries may choose to assess exposure (against which they must hold a cushion of capital) either by using the standardized method or by using banks’ own proprietary in-house models. Use of the latter option, known as the “internal models” approach, is subject to several requirements for prudence, transparency and consistency. When used appropriately, it can provide a significant improvement over the standardized method.
The internal models approach enables banks to take a broader view of their foreign exchange risk than does the standardized method. As described in the Basle Committee’s “Amendment to the Capital Accord to Incorporate Market Risks,” released in January of this year, the internal models approach focuses on evaluating the risks arising from banks’ trading activities. The approach is well-suited to incorporating the correlation between, say, the value of interest rate instruments and the value of foreign exchange. In principle, the internal models approach allows each bank to gauge its exposure carefully enough to incorporate the relationships among even its non-trading operations. However, even at its best, the internal models approach is limited in its range of coverage.
An even broader approach to assessing banks’ foreign exchange risks can be obtained from an analysis of banks’ equity returns. Equity returns reflect changes in the value of the firm as a whole. So, if the value of a bank as a whole is sensitive to changes in the exchange rate, the bank’s equity returns will mirror that sensitivity. Whether from direct or indirect sources, foreign exchange exposure will be reflected in the behavior of returns. Thus, the exchange rate sensitivity of a bank’s equity returns provides a comprehensive measure of its foreign exchange exposure.
One drawback of this equity approach is that it is not useful for evaluating the riskiness of a particular action. The approach is not linked to an explicit model of the determinants of foreign exchange exposure, so it cannot be used to trace out the implications of specific decisions. However, the approach is useful for bankers and regulators as a tool to evaluate the success of past management of foreign exchange risk. It is especially suitable for comparing the exposure of an assortment of banks because it can be applied consistently across banks and because it does not require access to their detailed internal models. Moreover, its comprehensiveness makes it a good benchmark for evaluating other gauges of exposure.
Chamberlain, Howe, and Popper (1995) used the equity approach to examine the overall foreign exchange exposure of a number of the largest U.S. bank holding companies and Japanese banks. The results showed that the equity returns of a substantial fraction of the U.S. bank holding companies were in fact sensitive to changes in the foreign exchange value of the dollar, but they were not very sensitive. Only a small part of the total variability of each company’s returns could be attributed to the effect of fluctuations in the exchange rate. To the extent that their returns did move with exchange rates, they typically moved in the same direction as the foreign exchange value of the dollar. That is, the bank holding companies benefited when the dollar rose and suffered when it fell: They were, in effect, “long” in dollars.
The predominately long dollar position of the U.S. bank holding companies was echoed in their holdings of foreign assets and liabilities: As a group, they held negative net foreign assets (their foreign liabilities exceeded their foreign assets). The study also found that their net foreign asset holdings were negatively related to their overall foreign exchange exposure. Since many foreign assets and liabilities are denominated in foreign currencies, the negative relationship between net foreign assets and exposure should not be too surprising: Acquiring assets denominated in foreign currencies offsets the long dollar position, as does shedding liabilities denominated in foreign currencies. The overall foreign exchange exposure also was negatively related to the companies’ use of off-balance sheet foreign exchange contracts. While such contracts often are thought of as risky, this evidence supports the opposite conclusion: These contracts apparently served to hedge the foreign exchange exposure of the bank holding companies.
The large Japanese banks, as a whole, appeared to be even better hedged against exchange rate risk. The returns of only a very few Japanese banks exhibited any sensitivity to changes in exchange rates. It is also the case that the Japanese banks typically hold a much larger share of foreign assets than do U.S. banks. If banks tend to be long in their own currencies, such holdings of foreign assets would serve to hedge their underlying positions. The lower foreign exchange exposure of the Japanese banks also may reflect a number of other factors, such as differences in the structure of ownership, in securities and derivatives laws, and in supervision.
This Economic Letter started by asking whether the large U.S. bank holding companies have taken on substantial foreign exchange exposure. Have they? According to the comprehensive gauge of exposure provided by the equity approach, the answer is no. While some of the bank holding companies certainly are exposed to foreign exchange fluctuations, such fluctuations contribute only slightly to the overall variability in their returns. Has their use of foreign exchange contracts added to that risk? No; on the contrary, the use of foreign exchange contracts has been associated with lower, not higher, foreign exchange exposure. Finally, how do the big Japanese banks compare? The big Japanese banks appear to be even better hedged against foreign exchange fluctuations than the big U.S. bank holding companies.
These observations provide some reassurance that the ever-expanding market for foreign exchange need not imply that banks are increasingly vulnerable to foreign exchange risk. However, this evidence does not indicate that we should be complacent regarding banks’ future exposure. For one thing, these assessments of overall foreign exchange exposure say little about the possibilities for abuses by individual rogue traders. Secondly, the assessments reflect the past behavior of banks. Banks always will have the capacity to take on additional risk in the future. Past discretion is no guarantee of future prudence. This is as true for foreign exchange risk as it is for interest rate risk and credit risk.
Visiting Scholar FRBSF
Assistant Professor of Economics
Santa Clara University
Basle Committee on Banking Supervision. 1996. “Amendment to the Capital Accord to Incorporate Market Risks” (January).
Chamberlain, Sandra, John Howe, and Helen Popper. 1995. “The Exchange Rate Exposure of U.S. and Japanese Banking Institutions.” Federal Reserve Bank of San Francisco Center for Pacific Basin Monetary and Economic Studies Working Paper No. PB95-11 (December).
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