Management of FX settlement risk in Hungary (Report II)

The concept known as FX settlement risk (aka Herstatt risk) came into focus some thirty years ago when Bankhaus Herstatt, a small German bank, became insolvent leaving its counterparties with credit exposure equivalent to the nominal value of receivables in US dollar from FX transactions, for which they had already transferred their payables in Deutsch mark to the failed bank. There was no way to withdraw their payment orders. These events, however, shed some light on the – usually significant – risks inherent in clearing and settlement procedures of financial transactions. Under the aegis of the Bank for International Settlements (BIS), central banks set out in 1996 to take joint action and find a solution for this matter. They consequently came up with a methodology, which is now broadly used by a great many central banks for mapping and measuring FX settlement risk. The MNB undertook an analysis among banks active on the FX markets with questionnaires following the BIS methodology and personal interviews for the first time in October 2000, and published the results and observations in 2001 (MNB, 2001) under the title ‘Management of FX settlement risk in Hungary’. As the FX trading data indicated significant risks faced by the Hungarian banking system in terms of FX settlement, in 2005 the MNB decided to revisit the same area and conduct a survey similar to the review completed in 2000. The MNB received a significant boost in its efforts early in 2006 when BIS announced its intention to conduct a survey of the subject once again among the G10 central banks. The objective of this study is to analyse – relying on 2006 data – FX settlement risk that may arise in the domestic banking system under its current operations, and to chart the changes which took place after 2000, covering improvements and, if necessary, formulating (new) recommendations to reduce risks. As will be referred to in many cases, this study actively relies on the material published in 2000, including the methodology it describes in detail. As a number of central banks (for example Riksbank and Norges Bank) are using the BIS methodology plus other (regular and specific) statistical reports to analyse FX settlement risk in the credit institution sector, along with all its consequences for financial stability, this latest analysis involves a deeper approach, reaching somewhat beyond the constraints of the 2000 publication. In the first chapter we will demonstrate how FX settlement risk is treated among other risks to which banks are exposed, including its dimensions and the impact it may have on financial stability, and the means available to reduce risks in general. The second chapter contains a brief description of the 2006 survey and a summary of general views and overall concepts relating to the information obtained through the questionnaires and personal interviews. The third chapter provides an analysis of the data conveyed in the 2006 survey and – minus the composition effect – a comparison of the results from 2000 and 2006. The fourth chapter offers an overview of the personal interviews, and at the end a summary of the results, conclusions and recommendations for future purposes, where deemed necessary.