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July 22, 1983
Banksand Foreign ExchangeMarkets
In 1 974, losses from foreign exchange
trading led to the insolvency of two banksFranklin National in the United Statesand
Bankhaus I. D. Herstatt in West Germany.
Several years later, between the summer of
1 977 and November of 1978, the dollar fell
in value against the German mark, the
Japanese yen and the Swiss franc.
contrasts with a "spot" contract in which a
buyer receives the currency two days later.
The rate at which the currencies are exchanged, the forward or spot rate, is determined at the time the parties enter into the
contract. In Franklin's case the currencies
were worth less than their purchase price
when the forward contracts matured.
These seemingly unrelated events crystalI ize the concerns of pol icymakers about
commercial bank foreign exchange trading.
One concern has been that such trading
involves undue risk that might be a source of
bank insolvency. A second has been that
banks engaging in foreign exchange trading
for speculative purposes may influence
exchange rates.
Federal officials declared Franklin insolvent
on October 8, 1974. While details of the
Franklin story were still unfolding, the
Bundesbank, West Germany's central bank,
announced the liquidation of one of its most
active trading banks, Bankhaus I. D. Herstatt
KG. The reason given for closing the bank
was heavy foreign exchange trading losses,
although the precise nature of the transactions was not revealed. In the same year,
Wesdeutsche Landesbank Gironzentral of
West Germany and Union Bank of Switzerland both sustained "hefty" lossesrelated to
foreign exchange.
These concerns have prompted a number of
studies by economists. Early studies, done at
the Federal Reserve Board, focused on the
priorities of regulatory agencies and committees. More recently, economists have
been freed from the constraints of congressionally mandated studies and with
increased institutional knowledge about the
worki ngs of foreign exchange markets, have
begun to focus on different issues. The various studies of bank participation in foreign
exchange markets will be examined here.
Causes for concern
The initial concern about commercial bank
foreign exchange trading was sparked by the
problems of four banking institutions around
the world. In early May of 1974, Franklin
National, then the twentieth largest bank in
this country in terms of assets,announced
that it had lost $12 million because of unauthorized foreign exchange trading.
Policy responses
The immediate official response varied. In
1 974, German bank regulators moved to
limit banks' net open positions-the difference between bank foreign currency assets
and liabilities-to
twenty percent of bank
capital. The United Statesconsidered
similar regulation while strengthening its
supervisory efforts. The FDIC, for example,
revised questionnaires for its examiners' use
in investigating foreign exchange trading
operations, and the Federal Financiallnstitution Examination Council (FFIEC)published guidelines for the conduct of trading
operations. One guideline recommended
that banks set their own c1ose-of-day
position limits.
The bank's losses were apparently caused
by forward transactions. In a forward contract, the buyer agrees to purchase a specified amount of currency on a specified date,
usually several months in the future. This
Earlier, in response to the dollar devaluation in 1973, the U.S. Treasury had begun to
collect weekly data on the c1ose-of-day
foreign currency net positions of the most
active trading banks in this country. In 1975,
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it began to publish this data monthly in the
TreasuryBulletin.The dollar depreciation
between 1 977 and 1 978 brought renewed
interest in official circles about the influence of bank foreign exchange trading
on exchange rates. The Senate committee
on Banking, Housing and Urban Affairs
conducted inquiries into the operation of
foreign exchange markets in both 1978 and
1979. Senator Proxmire voiced the Com-
on its open position when exchange rates
move counter to expectations. Bradshaw
concluded that net open exposure in practice is likely to be a much smaller percentage
of capital than the 10 to 20 percent figure
mentioned above. The small size of net positions relative to equity capital also led
Bradshaw to the conclusion that net open
exposure would be an unlikely source of
future bank insolvency.
mittee's primary concern:
In their 1 980 study, "U. S. Banks, Exchange
Markets, and the Dollar, Sept.-Nov. 1 978,"
Board Economists Ralph Smith, Jr.and
Barbara Lowrey examined data collected in
a survey of bank foreign exchange trading
and position taking activity: "The Survt'W
was requested in hopes of shedding addi""·
tionallight on allegations that the speculative activities of large trading banks were
responsible for the severe selling pressureon
the dollar in October 1 978." They found'
"no indication that changes in U.S. banks'
positions 'drove' exchange rates in one way
or the other" during the period.
"There have been accusations made ...
Some banks are so huge that a few
working together perhaps could push
the rates in a chosen direction ... we
owe the public as well as the banks ... a
thorough and careful inquiry •..." .
The studies prompted by the policymakers'
concerns over potential bank insolvency
and the influence of banks on exchange
rates were conducted at the Board of Governors of the Federal Reserve System.
Federal Reserve Board studies
Robert Bradshaw's study, "Foreign
Exchange Operations of U.s. Banks," was
undertaken because regulatory reforms that
"might be implemented to limit bank's
exposure to foreign exchange losses" were
being considered. Bradshaw was primarily
trying to determine whether net open positions were so large that the associated exchange rate risk threatened bank solvency.
Whenever an open position or exposure
exists, exchange rate fluctuations will
change its value and cause a profit or loss.
Lowrey and Smith attributed the lack of a
statistically significant influence of bank
changes in positions on exchange rates to
the small size of variations in bank's positions "relative to the variation in other
market participants' positions."
New York Fed studies
In 1977, and again in 1980 and 1983, the
Federal Reserve Bank of New York conducted surveys of foreign exchange market
turnover that have provided information
about the magnitude of the market and
about different types of market transactions.
In the New York Fed's Autumn 1981 Quarter/y Review,Patricia Revey made extensive
useof the turnover surveys in an article
entitled "Evolution and Growth of the U.S.
Foreign Exchange Market." In 1978, a mon;ograph by Roger Kubarych entitled Foreign
ExchangeMarketsin the UnitedStatestried
to explain how the market works and how
banks operate in it.
Bradshaw attempted to measure "net open
position exposure" by using the limits 35
banks had imposed on their own net open
positions. He totalled the limits in several
currencies and calculated the ratio of this
total to bank equity capital. Bradshaw found
this ratio to be "in the 10 to 20 percent
range" for most major money center banks.
He observed that a bank rarely Usesits limits
in all currencies simultaneously and that a
bank is not likely to suffer a 100 percent loss
2
Both studies discussed the nature of bank net
positions by examining the extent to which
they are deliberately assumed. It is clear that
banks must take positions to serve their
customers. For example, if a customer sells
OM, the bank becomes a buyer and has a
positive or "long" net position. A bank wishing to avoid as much risk as possible can
have its traders enter the market "only when
they have commercial orders to cover," that
is, the bank can follow a "sequential
approach." In this example, the bank would
"cover" the position created by the customerdeal by going into the marketto sell
the same amount of OM it had purchased.
they may diminish the need for exchange
rate adjustments to correct the imbalance.
Conclusion
The initial studies on commercial bank
participation in foreign exchange markets
necessarily focused on the size of bank net
positions and the potential of banks for
influencing exchange rates. Although these
studies concluded that U.S. bank positions
were not likely to cause insolvency or to
influence exchange rates, it would be a
mistake to infer that bank participation does
not affect the operation of foreign exchange
markets. Revey's work suggeststhat the
potential bank influence on exchange rate
variability must also be considered. Stanford
University Professor Ronald McKinnon has
argued that a lack of commercial bank
position-taki ng can actually be a source
of instability in the foreign exchanges.
Kubarych observes that it is virtually impossible for an active bank to take a "sequential" approach. Similarly, Revey argues
that the $38S billion increase in foreign
exchange turnover between the 1 977 and
1980 surveys cannot be attributed solely
to attempts by banks to cover an increased
amount of customer transactions. She estimates that half of the increase was due to
banks that entered into transactions in the
hopes of profiting from exchange or interest
rate movements. Her finding suggeststhat
a significant amount of foreign exchange
activity is due to banks that deliberately take
a net open position.
The feverish concern about foreign exchange trading caused by the bank failures
and exchange market turmoil of the seventies has subsided, but the subject is still
of more than academic interest. All major
central banks want to keep track of and,
at times, influence exchange market conditions. For this reason, they need to understand how the market operates. Perceptions
of the effects of bank exchange trading also
are likely to influence the policies of regulatory authorities in the future. For example,
as recently as March of 1983, the Australian
central bank ordered its commercial banks
to stop all trading not directly related to
customer orders. Traders have asked for a
reconsideration of this directive. How the
Australian central bank, for one, views the
role of the banks in the foreign exchange
markets is sure to influence its ultimate
decision.
Revey and Kubarych agree that banks do
more than merely respond to the open position thrust upon them by customer service.
They contend that banks have desi red net
open positions based on anticipated rate
movements and that they use the market t9
reconcile their desired positions with the
ones dictated by customer transactions.
Revey also suggeststhat commercial bank
positions may play the role of inventories in
the market. In her view, the willingness of
banks to hold net open positions may influence exchange rate variability: when bank
holdings of foreign exchange adjust to
accommodate excessesof supply and
demand in the foreign exchange market,
H. RandiDeWitty
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BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
SelectedAssetsandLiabilities
LargeCommercialBanks
loans (gross,adjusted)and investments"
loans (gross,adjusted)- totaJ#
Commercialand industrial
Realestate
Loansto individuals
Securitiesloans
U.S.Treasurysecurities"
Other securities*
Demanddeposits- total#
Demanddeposits- adjusted
Savingsdeposits- totalt
Timedeposits.- total#
Individuals,part.& corp.
(La"e neQotiable CD's)
WeeklyAverages
of Dailv Fiuures
Member BankReservePosition
Amount
Outstanding
716183
163,112
141.676
44.262
56,063
23,919
2.612
8,375
13,060
45,985
29,901
67,268
65,298
59,589
19 147
Weekended
716 183
ExcessRes€lVes(+ )/Deficiency (-)
Borrowings
Net (reereserves(+ l/Net borrowed{-)
-
14)
807
666
Change
Change from
year ago
from
6129183
Dollar
-
24
29
- 76
- 170
19
8
109
- 161
4,598
1,344
1,089
- 426
- 111
229
-
Weekended
6 129 183
-
108
812
705
Percent
1.912
1,294
102
1,273
581
428
1,778
1.161
3,705
1,821
36,002
31,198
27,557
16572
1.2
0.9
0.2
- 2.2
2.5
19.6
27.0
- 8.2
8.8
6.5
115.1
- 32.3
- 31.6
46.4
Comparable
\learMa':'oru:>riod
97
50
46
* Excludestradingaccountsecurities.
# Includesitemsnot shownseparately.
t IncludesMoneyMarketDepositAccounts,Super"NOWaccounts,and NOW accounts.
Editorial commentsmaybeaddressedto the editor (GregoryTong)or to the author.... free copies
of this and other federal Reservepublicationscanbe obtainedby callingor writing the Public
Information Section,FederalReserveBankof SanFrancisco,P.O.Box7702,SanFrancisco94120.
Phone (415) 974-2246,
@FedFRASER