1. Background
Risks accompanying foreign exchange operations are mounting in Korea due to increased multi-national transactions, financial deregulation, tougher competition among financial institutions and the introduction of derivatives.
However, foreign exchange management by the Foreign Exchange Management Act has been enforced mainly through focusing on aspects of the management of external assets and liabilities.
○ The supervision of foreign exchange operations, executed mainly by the central bank, has given more weight to the stability of the foreign exchange market and monetary policy, rather than to assuring the soundness of commercial banks.
〓> The supervisory function was not sufficient to manage the various risks, which may arise in foreign exchange operations, such as exchange risk, credit risk, liquidity risk, market risk, etc..
○ It is necessary to strengthen prudential supervision over banks' foreign exchange operations, in order to prevent recurrence of the foreign exchange crisis through efficient management of the risks inherent in foreign exchange operations.
2. Contents
◎ In order to efficiently manage various risks in foreign exchange operations, the Banking Supervisory Authority is taking comprehensive measures.
○ The foreign currency liquidity regulation system will be modified to enforce the Maturity Mismatches(GAP) Regulation, as well as the Foreign Currency Liquidity Ratio Regulation.
○ The banks will set up and manage the limits on their foreign exchange operations under the Guidelines of the Banking Supervisory Authority.
○ The Banking Supervisory Authority is also strengthening its off-site surveillance by improving banks' reporting systems, in order to facilitate risk evaluation and assure the soundness of foreign exchange operations in commercial banks.
1) Strengthening of supervision on liquidity risk
Introduction of the Maturity Mismatches(GAP) Regulation
○ After dividing assets and liabilities into 7 buckets1) according to their residual maturities, banks will have the obligation to maintain minimum ratios of cumulative GAP amounts to total foreign currency assets in the first two buckets, as follows. As agreed upon with the IMF, the ratio must be positive for the first bucket of no more than 7 days, -10% for the period of no more than 1 month. In addition, it must be -20% for the period of no more than 3 months.
(1) 0∼7days, 8days∼1month, 1∼3months, 3∼6months, 6months∼1year, 1∼3years, above 3 years
(2) GAP ratio in each period=(accumulated foreign currency liquid assets - accumulated foreign currency liquid liabilities)/total foreign currency assets
(3) Marketable securities with certain discount rates will be counted as assets of the first bucket.
○ This regulation will be enforced on a consolidated basis, encompassing the accounts of banks' headquarters, domestic branches, overseas branches, overseas subsidiaries and their off-shore accounts.
Improvement of the current Foreign Currency Liquidity Regulation
○ The ratio is currently calculated as foreign currency assets over foreign currency liabilities with residual maturities of no more than 90 days. The standard liquidity ratio under the current foreign currency liquidity regulation, over 70%, will be maintained.
○ However, the ratio will be newly calculated through inclusion of foreign currency assets and liabilities of overseas subsidiaries and off-shore accounts, in addition to the assets and liabilities of both headquarters and domestic/overseas branches.
○ The Banking Supervisory Authority will strengthen to monitor banks' observance of the ratio every month, which has been currently monitored every three months.
2) Overall exposure limit on credit risk
Each bank will introduce for itself overall foreign currency exposure limits(e.g., 10% of equity capital) on a counterparty. Overall exposure regulated by this limit will comprise foreign currency loans, foreign currency guarantees, foreign currency security investments and off-shore finance.
○ In addition, each bank will introduce stricter limits(e.g., 5% of equity capital) for exposure to a counterparty whose credit rating is lower than BBB- on an S&P basis.
As for foreign currency security investments, each bank will introduce a ceiling of a specified portion of its total security investments(e.g., 30%), on investment in below-investment-grade securities, as valued by international credit rating institutes.
Each bank will introduce a ceiling of a specified portion of its equity capital(e.g., 5%) on its overall exposure to paper companies such as off-shore funds.
3) Country Risk Management
Each bank will set up and observe for itself overall exposure limits to a country as follows:
○ After classifying countries in 3 groups by the country's credit ratings with international credit rating institutes such as S&P, Moody's, etc., for example, Strong Country(AAA∼AA-, the credit ratings on the S&P basis), Moderately Strong Country(A+∼BBB-, the same basis) and Weak Country(BB+∼D, the same basis), specific limits will be imposed on each country.
○ At the same time, an additional ceiling on total investment in the group of Weak Countries will be set at a specific portion(e.g., 30%) of the bank's equity capital.
4) Risk Management for Derivatives
Considering the fact that derivative transactions have huge notional values and complicated and sophisticated structures, it is necessary to strengthen banks' own internal control systems for derivative transactions.
○ For non-plain-vanilla derivatives, defined as compounded derivatives or those with complicated terms of transaction, and large notional amount transactions, banks will analyze the risks in their Internal Risk Management Committees including ALM committees before making decisions.
○ In cases in which non-plain-vanilla transactions and large-valued transactions are related with credit risk, approval from a bank's loan committee will be needed.
5) Improvement of Foreign Currency Risk Management System
Early establishment of foreign currency ALM system
○ In the long term, it is desirable that all parts of a bank's risk management be carried out under a system consolidating the local currency(Won) and foreign currency ALM systems.
○ In the short term, banks will be guided toward early establishment of foreign currency ALM systems, considering that many banks don't have foreign currency ALM systems even though all banks have already adopted the Won ALM systems.
Establishment of exclusive organizations for risk management
○ While organization for risk management has been established inside banks' Planning Departments and has consisted of directors of related departments, it is necessary to establish an independent department in each bank, of which the main duties will be to set up various limits on risks and check compliance.
6) Strengthening of off-site surveillance
The Banking Supervisory Authority is strengthening its off-site surveillance by improving banks' reporting systems in order to aid in evaluation of various risks and assure the soundness of foreign exchange operations in commercial banks.
○ The improved system includes reporting on
① the state of banks' foreign currency borrowing,
② the state of overall foreign currency exposure to counterparties,
③ the state of investment with counterparties whose credit ratings are lower than investment grade,
④ the state of investment in foreign currency securities,
⑤ the state of investment in foreign currency assets of paper companies including SPCs,
⑥ the state of foreign currency investments to individual countries,
⑦ the state of exceptional approvals by each bank's Risk Management committee,
⑧ the state of management in relation to derivative transactions and associated risks.
3. Enforcement date
Effective from July 1, 1998
○ However, the Maturity Mismatches(GAP) Regulation will be enforced in the latter half of this year, in consideration of the lengthy preparation period needed by banks.