FX Lending Risk

Definition

FX Lending Risk denotes the specific combined credit and market risk sensitivity of lending products that belong the FX Lending category (lending denominated in a currency other than the domestic currency of the borrower)

Risk Factors

The credit risks associated with FX lending derive from the fact that exchange rate movements influence a borrower’s debt-servicing capacity, and potentially also the exposure at default and the value of the loan collateral (if applicable).

Regulatory Capital

Pillar I

The Basel II Pillar I framework does not have any provisions for capitalizing the additional risk inherent in FX lending. This means that even if the risk classification and Risk Parameters such as Probability of Default and Loss Given Default used for FX loans properly capture the full impact of FX risk in credit performance, it is unlikely that use of such FX sensitive credit parameters with one of the capitalization options offered by Basel II will capture the tail risks inherent in an FX lending portfolio. This is explicitly not the case in the A-IRB context, where modelled Tail Risk is solely driven by a single systemic factor and has been (roughly) calibrated to the volatility of generic portfolios.

Pillar II

Additional capital requirements for FX lending maybe required by local regulators as part of the ICAAP (Pilllar II). As ICAAP methodologies are generally not public it is not possibly to list here any approaches followed.

Stress Testing

Guidance on stress testing FX lending portfolios is provided in EBA 2018 EU-Wide Stress Test. Banks with significant foreign currency lending exposure must take into account the altered creditworthiness of their respective obligors, given the FX development under baseline and adverse scenarios. The marginal impact from the risk emanating from FX lending exposure has to cover both transition rates (to different crediworthiness scales) and loss rates. For transition rates, the impact should be based on satellite models that link the macroeconomic scenario to the transition rates. For the loss rate, the impact should be based on an add-on for the LTV ratio in the case of collateralised exposures, while, in the case of uncollateralised exposures, banks should apply the appropriate FX add-on based on relevant historical information.

Legal Risk

FX Lending carries (other things being equal) increased Legal Risk versus home currency lending. In a recent decision the European Court of Justice stated: When a financial institution grants a loan denominated in a foreign currency, it must provide the borrower with sufficient information to enable him to take a prudent and well-informed decision. Therefore, the seller or supplier must communicate all relevant information to the consumer concerned to enable him to evaluate the economic consequences of a clause on his financial obligations

Issues and Challenges

• FX lending risk is a recurring challenge, in particular in relation with emerging markets
• Methodologies for measuring and capitalizing FX lending risk are immature and hampered by the complicated dependency of market and credit risk factors

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