There are various risks involved in foreign dealings for a bank. The Dealing Room is rightly identified as a profit center for a bank. But at the same time, it may not be forgotten that any scope for profits is associated with the risks of losing. It is more so in the case of foreign exchange dealing where the vagaries of the market can play havoc. Unbridled enthusiasm has to be monitored so that the bank does not expose itself to unduly huge risks.
The following are the major risks in foreign exchange dealings: (a) Position Risk (b) Cash balance risk (c) Maturity mismatches Risk (d) Credit Risk (e) Country Risk (f) Over-trading Risk (g) Fraud risk (h) Operational Risks.
1. Open Position Risk: The open position risk or the position risk refers to the risk of change in exchange rates affecting the overbought or oversold position in foreign currency held by a bank. Hence this can also be called the rate risk. The risk can be avoided by keeping the position in foreign exchange square. However, in practice, keeping an open position becomes inevitable due to various reasons like delay in getting reports from branches, non-availability of suitable cover in the market etc.
Each bank fixes a ‘day-light limit’ or ‘intra-day limit’ for each currency. This is the limit up to which the dealer can deal himself without reference to higher authorities. For instance, bank may fix the daylight limit for US dollar as USD 5 million. That means the dealer can purchase and sell dollars so long as the balance outstanding at any time during the day is not exceeding USD 5 million.
In addition the bank also fixes an ‘overnight i.e., the extent to which the currency position can be kept open at the end of the day. Normally the over-night limit would be much less than the daylight limit. While the daylight limit ensures that the bank does not acquire very large position in the currency which it may find it difficult to cover in the market, the overnight position puts a ceiling on the exchange risk to the bank. Apart from the above limits on individual currencies, the bank would also place an aggregate limit on the foreign exchange position for all the currencies put together. This would be smaller than the total of individual overnight limit for each currency.
2. Cash Balance Risk: Cash balance refers to actual balances maintained in the Nostro accounts at the end of each day. Balances in Nostro accounts do not earn interest; while overdraft involves payment of interest. The endeavor should therefore be to keep the minimum required balances in the Nostro accounts. However, perfection on this count is not possible. Depending upon the requirement for a single currency more than one Nostro account may be maintained. Each of these account is operated by a large number of branches. Communication delays from branches to the dealer or from the foreign bank to the dealer may result in distortions. The banks endeavor to obtain the statement of accounts from foreign banks on a daily basis through telecommunication and monitor closely the balances in Nostro accounts. Reconciliation of balances of Nostro accounts almost on a continuous basis also helps in this regard.
3. Maturity Mismatches Risk: This risk arises on account of the maturity period of purchase and sale contracts in a foreign currency not coinciding or matching. The cash flows from purchases and sales mismatch thereby leaving a gap at the end of each period. Therefore this risk is also known as liquidity risk or gap risk.
Mismatches in position may arise out of matching cover, small value of merchant contracts, the customers exercising their options on different dates etc. Mismatch may also be deliberately created by the bank to minimize swap costs or to take advantage of changes in interest differential or the large swings in the demand for spot and near forward currencies.
The mismatch can be corrected by undertaking a suitable swap. The risk involved is that the cost of swap may turn out to be higher than that provided for.
Internal control: At monthly intervals the purchases and sales are segregated monthly wise and the net balance arrived as described. The following gap limits are pre-limit.
(a) A monthly gap limit for each currency. This is called the individual gap
(b) A cumulative gap limit for all maturities for each currency which would be less than the total of monthly gap limits.
(c) Cumulative gap limit for all currencies put together which would be less than the total of cumulative gap limit for all currencies.
Maturity limit. Apart from the above, the bank may also fix the maximum period up to which forward cover can be offered to the customer. This depends upon the maximum maturity for which cover will be available in the market.
4. Credit Risk Credit risk is the risk of failure of the counter party to the contract. Credit risk is classified into (a) contract risk and (b) clean risk.
Contract risk arises when the failure of the counter party is known to the bank before it executes its part of the contract. Here the bank also refrains from the contract. The loss to the bank is the loss arising out of exchange rate difference that may arise when the bank has to cover the gap arising from failure of the contract.
Clean risk arises when the bank has executed the contract, but the counter party does not. The loss to the bank in this case is not only the exchange difference, but the entire amount already deployed. This arises, because, due to time zone differences between different centers, one currency is paid before the other is received.
Internal control. The risk is controlled by fixing counter party limits, both for banks and merchant customers. Limits are fixed on the aggregate outstanding commitments and separately for the amount of funds to be settled on a single day.
5. Country Risk: Also known as ‘sovereign risk’ or ‘transfer risk’ country risk relates to the ability and willingness of a country to service its external liabilities. It refers to the possibility that the government as well other borrowers of a particular country may be unable to fulfill their obligations under foreign exchange transactions due to reasons which are beyond the usual credit risks. For example, an importer might have paid for the import, but due to moratorium imposed by the government, the amount may not be repatriated. Internal control. The country risk analysis is made by taking into account the socio-economic and political situation of the country and a limit for exposure for that country is fixed.
6. Over-trading Risk: A bank runs the risk of over-trading if the volume of transactions indulged by it is beyond its administrative and financial capacity. In the anxiety to earn large profits, the dealer or the bank may take up large deals, which a normal prudent bank would have avoided. The deals may take speculative tendencies leading to huge losses. Viewed from another angle, other operators in the market would find that the counter party limit for the bank is exceeded and quote further transactions at higher premiums.
Expenses may increase at a faster rate than the earnings. There is therefore a need to restrict the dealings to prudent limits.
Internal control: The tendency to over-trading is controlled by fixing the fol-lowing limits: (a) A limit on the total value of all outstanding forward contracts (forward limit).
(b) A limit on the daily transaction value for all currencies together (turnover limit).
7. Fraud Risk: Frauds may be indulged in by the dealers or by other operational staff for personal gains or to conceal a genuine mistake committed earlier. Frauds may take the form of dealing for one’s own benefit without putting them through the bank accounts, undertaking unnecessary deals to pass on brokerage for a kick back, sharing benefits by quoting unduly better rates to some banks and customer etc. The losses from such fraudulent deals can be substantial.
Internal control. It is imperative that dealers be well supervised, honest and well trained. Proper selection and proper training therefore play an important role.
The following procedural measures are taken to avoid frauds: (a) Separation of dealing from backup and accounting functions. (b) Ongoing auditing, monitoring of positions etc., to ensure compliance with procedures. (c) Regular follow-up of deal slips and contract confirmations. (d) Regular reconciliation of Nostro balances and prompt follow-up of un-reconciled items. (e) Scrutiny of branch reports and pipeline transactions. (f) Maintenance of up-to-date records of currency position, exchange position and counter party registers etc.
8. Operational Risks: These risks include inadvertent mistakes in the rates, amounts and counter-parties of deals, misdirection of funds etc. The reasons may be human errors or administrative inadequacies. The deals are done over telecommunication and mistakes may be found only when the written confirmations are received later. But reversing such mistakes may involve exchange rate and interest losses for the bank. If Nostro reconciliation is not proper, the mistakes may remain undetected for long periods. By the time they are found out, the relevant records may not be available any more. Internal control. The internal control measures are same as that for preventing frauds.