Question Enn Finance & Economics

Currency Management in the Banking Sector

Discuss the importance of foreign exchange management for the survival and viability of a treasury function in the banking sector.

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Answer Expert #27149

Alongside the opportunities of globalisation, this phenomenon has also brought about a number of financial risks that businesses operating internationally (including but not limited to the commercial banking sector) must manage (Puma and Lee, 2004). Commercial banks are particularly susceptible to foreign exchange risk. Some of the banks’ assets might be held in a foreign currency, so any movement of a given currency pair (such as the GBP-EUR) could have negative financial implications for the organisation (Jacque, 1996). Therefore, banks must implement practices to limit their currency risk exposure, which is possible through a prudent treasury function utilising various derivative financial instruments to mitigate FOREX risk.

Many banks in the late 2000s issued loans nominated in foreign currencies (mostly in Swiss francs) because these loans offered lower interest rates for applicants, however, such loan arrangements also included a foreign exchange risk (Freixas et al. 2015). The sudden appreciation of the Swiss franc contributed to the high number of loan defaults that created liquidity problems for banks. The role of the treasury function (or a treasury department) in a bank is to ensure that at any given time, a sufficient amount of liquidity is available to ensure a continuous and safe operation. The most frequent risk management tools are hedging and netting strategies against currency movements (Weetman, 2013). If these risk management tools are appropriately applied, sudden value changes in a commercial bank’s assets (due to currency movements) can be managed even in a volatile and uncertain business environment.

References

Freixas, X., Laeven, L. and Peydro, J.-L. (2015) Systemic risk, crises, and Macroprudential regulation. United States: MIT Press.

Jacque, L. L. (1996) Management and control of foreign exchange risk. Boston: Kluwer Academic Publishers.

Puma, E. and Lee, B. (2004) Financial derivatives and the globalization of risk. Durham, NC: Duke University Press.

Weetman, P. (2013) Financial and management accounting: An introduction. Harlow, United Kingdom: Pearson Education.