05 June 2009

Limiting Proprietary Foreign Exchange Trading

Apart from maintaining a book to facilitate foreign exchange transactions with their non-bank customers, should banks engage in proprietary foreign exchange trading i.e., speculating for their own account?

Many banks have systems which try to quantify the potential loss of their trading positions under certain stress scenarios.  Such systems usually work well, provided the mathematical models on which they are based correctly reflect historical experience and then, only to the extent that historical experience can accurately predict future exposure.  However, markets have fat tails (periodic, albeit infrequent, price movements that are much larger than predicted by most finance theory) which may not have been built, or not adequately built, into their models.

Even with capital adequacy ratios in the mid-teens, banks are more highly leveraged than many other companies.  A bank with a capital adequacy ratio of, say, 15 per cent, has 6.67 times as much risk-weighted assets as capital, and this is after taking the credit risk of not-so-risky assets at less than their full face value.

When banks falter, either depositors lose their money or governments rescue them with taxpayers' money.

Risks aside, a more fundamental question is this is speculating on currency movements a banking activity, or even a business activity?

Many people do not consider foreign exchange, or any other, speculation as a business activity of non-banks.

What differentiates banks from non-banks then?  Is it expertise or more sophisticated risk management systems?  Is it because banks have been doing it for years, perhaps profitably?  Or, is it some notion that it is a banking activity by reason that it involves currencies, economic analysis, etc.?

There's no difference, really.  If individuals wish to speculate, that is their prerogative.  But, companies banks as well as non-banks should not speculate.  Not as a business and not with money not theirs to risk.

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