Forex market: Managing the risk

Most of us would agree that we need to move out of this crisis and set forth bold footsteps in our pursuit of a strong and robust market. To do that we must understand what actually happened, what we did wrong and what we must do in future to prevent such undoing.

Before 1993, practically there was no interbank market. Banks used to buy/ sell foreign currency from Bangladesh Bank to cover their customer requirements. As there was no interbank market, banks would not do any transaction between themselves. As a result the market was highly illiquid and devoid of any supply/demand mechanism. When Bangladesh Taka ( BDT) was declared current account convertible in 1993, the situation started to change. Bangladesh Bank stopped providing the foreign currency window and encouraged the banks to trade between themselves. In this way, rapidly an interbank market started to grow. Banks found that the development of interbank foreign exchange market was helping them in providing their customers market based foreign exchange ( FX) rate. This created competition among the banks, which in turn generated tangible financial benefit for the customers. Also, this development provided the banks a new way of generating revenue. Earlier, the banks were dependent upon the interest income from loans and deposits as major source of revenue.

However, just as providing loans and taking deposits create risks and thus require establishment of appropriate risk management and internal control process and procedures, trading in the foreign exchange market also create such risks and require establishment of adequate risk management devices/ tools.

Now, what do we understand by these risk management and internal control processes for foreign exchange operation? Global foreign exchange market is a 24-hour trading and can even be very volatile. To protect the foreign exchange operation of a bank from such volatility. the foreign exchange and money market activities of the bank need to be centralised under an independent Treasury. Treasury would only do the transactions. The settlement of these transaction would have to be done by a separate independent unit called 'Treasury Operations' or 'Treasury Back Office'. The back office would not only settle the transactions, but also monitor whether the dealers are complying with various limits imposed by internal risk management and external regulators like Bangladesh Bank. There has to be strict adherence to counter party risk limit, dealer's individual limit, stop-loss limit, net open position limit and many others. Internal auditor of the bank should regularly review the process as well as actual transactions to make sure that all the foreign exchange activities are being done in accordance with the bank's declared policies and rules and regulations of Bangladesh Bank. Not only the internal auditor but also the external auditors should verify this.

In recent times what actually happened was that some of the banks were trading in cross currencies with an expectation that the market would move favourably. However, the market moved against their views and their positions went wrong. To make the matter worse, the banks did not have sufficient control (both internal and external) mechanism to prevent the dealers from holding these positions for a prolonged period. As a result, these losses mounted up and severely damaged the capital of bank. The unfolding of these events reflects problems at various levels. The banks did not have sufficient internal control to capture the potential risk involved in such trading activities. This also means that banks have engaged in such activities without a proper understanding about the risk involved. The external controllers of the banks, like the auditors and various regulatory bodies failed to identify the problem and give cautionary signal. All these things lead to a major finding -- absence of clear understanding among dealers, internal and external auditor, and regulators.

Typical reaction to such crisis has been to vilify the trading activities and portray it as 'gambling', which is completely wrong. Trading is like any other revenue generating activities of a commercial bank, which involves assuming certain amount of risk. Just as by giving a loan to a customer the bank assumes risk, similarly by engaging into trading activities the bank also assumes risk. The important issue is how to manage this risk. To manage this risk, the banks should have proper risk mitigating and internal control processes in place. By stopping trading activities, the problem will not be solved, but create new one. Trading activities create liquidity in the market, eliminate volatility and increase transparency. All of these things at the end translate into substantial benefit for the end-users, the customers.

In our banking system, we have quite a few nationalised and private banks that have huge classified bad loans. Now, to solve this problem if we stop providing loans, that would create immense negative impact on the economy. Similarly, if we stop trading activities to solve the problem of these loss-making banks, it would deprive the economy of its growth momentum and stop the development of new product generation. This would ultimately create obstacle in implementing the liberalisation process we have vowed to continue. We can see a live example of this in our USD/BDT market where lack of liquidity has created a 'dual exchange rate' in the market and the customers are suffering unnecessarily.

The core issue of this crisis is coming to a single point -- Risk Management. We must establish proper processes to ensure that we are well aware of what risk we are assuming. This would require continuous training of the bankers, auditors (internal and external) and regulators. Bangladesh Bank has correctly moved forward and taken necessary steps to address the issue. We also should move forward with the lessons learned for building a strong and robust financial market.

Mamun Rashid is a banker.