Banks are underestimating the risk that their trading partners on the foreign exchange market may fail to honor commitments, global regulators said.
The Basel Committee on Banking Supervision issued draft guidance to lenders to bolster safeguards against the possibility that trades may break down before they are settled.
Banks should set binding limits on the amount of settlement risk they take onto their books, and restrict the amount of business they do with any single counterparty.
“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 Basel Committee said in a statement on its website. “While such risks may have a relatively low impact during normal market conditions, they may create disproportionately larger concerns during times of market stress.”
Transactions worth $4 trillion a day take place on global currency markets, according to figures from the Bank for International Settlements published in December 2010. The market grew by 20 percent from 2007 to 2010, the BIS said.
The draft rules tackle so-called Herstatt risk, namely 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 influenced regulators to set up the Basel Committee.
While banks and other institutions active in the currency markets have taken steps to make trading more robust, rapid growth means that “substantial” settlement risks remain, the group said.
The Basel regulators’ proposals also include banks seeking wherever possible to settle both sides of a trade simultaneously, and that they should hold “sufficient capital” against settlement risk.
The plans update guidance adopted by the Basel group in 2000. The committee will seek views on the proposals until Oct. 12.