Capital Adequacy and Foreign Exchange Risk Regulation

Abstract

Capital Adequacy and Foreign Exchange Risk Regulation: Theoretical Considerations and Recent Developments in Industrial Countries

Capital adequacy regulations put forward by the Basle Committee on Banking Supervision have virtually become an international standard of prudential regulation. Recent decisions by the Group of Ten and the European Union extend this approach to market risks, including foreign exchange risk. The present paper provides a discussion of exposure limits, as implied by capital adequacy requirements, mainly focusing on the example of currency risk. Some theoretical issues are addressed in the paper together with descriptions and comparisons of existing and future regulations, in 15 industrial countries. It turns out that previous forex exposure limits in many industrial countries were more restrictive than could be expected from purely prudential considerations. However, the newly adopted minimum requirements should lead to an alleviation of existing regulations. Furthermore, a change of approach by the Basle Committee, allowing banks to use their own risk management models, creates a coordination problem between G-10 and EU regulations, which requires an amendment (CAD II) of the 1992 Capital Adequacy Directive. It is also argued that prudential limits are not the appropriate instrument to fight speculative capital flows in developed financial markets.