Download Management & Engineering Management for Commercial Bank’s Exchange Rate

Management & Engineering 19 (2015) 1838-5745
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Management & Engineering
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Choice of Exchange Rate Regime and Innovation of Risk
Management for Commercial Bank’s Exchange Rate
Huijun LIU 1∗, Yong HONG 2
1. Postdoctoral Programme of China Industrial Economic Security Research Center of Beijing Jiaotong University
/ Research Center for Beijing Industrial Security and Development, 100044, China
2. Strategy & Planning Dept. China Life Insurance Company Limited, 100033, China
KEYWORDS
Exchange rate regime,
Commercial bank,
Exchange rate risk management,
Financial innovation
ABSTRACT
Exchange rate is an important part of international monetary system. Various domestic and
international political, economic and social factors can affect the choice of exchange rate
regime in one country. It is needed to choose the exchange rate regime by considering
domestic economic-social development and financial stability, especially the effect on sound
operation of commercial banks. Commercial banks should strengthen financial products
innovation management and constantly improve the exchange rate risk management.
© ST. PLUM-BLOSSOM PRESS PTY LTD
1 Introduction
Exchange rate is the most important adjustment lever in international trade. It means the ratio of a country’s currency to another
country. The level of the exchange rate will directly affect the price of goods in international market. With the deepening reform of
the exchange rate regime and capital account liberalization, the RMB exchange rate will change more frequently and make more
challenges of risk management to commercial banks. It seemed very important to strengthen exchange rate management risk control
and to promote the financial innovation in commercial banks.
2 Types and Comparison of Different Exchange Rate System
There are several exchange rate regimes in the world, including fixed peg, currency board, crawling band, managed float and free
float. Main exchange rate regimes are as follows:
2.1 Fixed exchange rate system
Fixed exchange rate system refers to each country can peg the value of its currency to gold to establish its par value. It is a relatively
stable exchange rate system. There are different fixed exchange rate systems in different currency systems.
The advantages of stable exchange rate can help to provide the basis for trade and investors, to establish a stable expectation, to
∗
Corresponding author.
E-mail address: [email protected]
English edition copyright © ST. PLUM-BLOSSOM PRESS PTY LTD
DOI:10.5503/J.ME.2015.19.008
43
reduce exchange rate risk and transaction costs, thus promote investment growth and international trade. Of course, there are some
disadvantages. Firstly, a country can’t achieve the fixed exchange rate system, free capital flows and monetary policy independence
happens at the same time according to Mundell’s theory. Secondly, fixed exchange rate system does not automatically correct
currency misalignment. Thirdly, fixed exchange rate system will increase the financial fragility, many financial crises occur in recent
years, mostly associated with the fixed exchange rate system. After World War II, Bretton Woods’s system established base on fixed
exchange rate system and capital controls①. However, with the system breakdown, the major international currencies and gold
decoupled, along with the disintegration of the fixed pegged exchange rate system.
2.2 Floating exchange rate system
Floating exchange rate system indicates that a country does not set limits the local currency and foreign currency gold parity and
exchange rate fluctuation, the exchange rate goes up and down according to market supply and demand.
There are three advantages of floating exchange rate system. Firstly, it can help to digest or absorb internal and external impact.
When the impact is useful, exchange rate will increase automatically, otherwise, it will automatically fall. Secondly, it can help to
maintain the independence of monetary policy, to make independent rapid response for internal and external shocks. Thirdly, when
market participants are aware of exchange rate risk to manage and avoid the risk through various financial tools. There are also
several disadvantages. Firstly, in floating exchange rate system, exchange rate fluctuated easily. It appears the imbalance of exchange
rate, especially in the short and medium term fluctuation [2]. Secondly, it might lead to speculative flow of international capital. When
expectation of a country’s currency appreciation is high, investors will increase their investments, otherwise, they will reduce
investments. Thirdly, it will cause the abuse of exchange rate policy against international economic cooperation. At last, it may lead
to price increased worldwide because of the ratchet effect.
2.3 Managed floating exchange rate system
Managed floating exchange rate will be decided by market supply and demand. Long-term trend of the exchange rate was not
affected by the government management but short term trend of exchange rate will be intervened or influenced by authority.
There are two advantages. Firstly, it fluctuates in a reasonable range and allows enough flexibility and to modify the exchange parity
according to the basic economic factors. Secondly, it can provide greater flexibility in space for the implementation of monetary
policy, reducing the risk of currency crises. However, because of the government or the central bank authorities can set the exchange
rate, floating exchange rate system may be abused as a policy management against neighbor countries.
In a word, whether an exchange rate regime suits a country, it all depends on specific economic and financial environment in this
country. No exchange rate regime is perfect, isolated from troubles and risks and no any kind of exchange rate system is suitable for
all countries all the time.
3 Choice of RMB Exchange Rate Regime
3.1 Factors affecting the choice of exchange rate regime
To a certain extent, a country’s exchange rate is decided by various political and economic factors. Different sectors of society will
have different exchange rate system and exchange rate pricing preference because of its own interests [1]. In a country, the exchange
rate is the result between interest groups and the government which has a certain political and economic policy objectives.
There are some factors affecting the choice of exchange rate regime. Firstly, economic and financial policies influenced the choice of
exchange rate regime. Research showed that, in given condition, financial policy is effective under a fixed exchange rate system, but
monetary policy is ineffective. Secondly, economic scale influences the choice of exchange rate regime. The larger economies are
more likely to choose floating exchange rate system to obtain the autonomy of monetary policy, smaller economies tend to choose
fixed exchange rate. Thirdly, trade dependence degree② influenced the choice of exchange rate regime. The higher degree of trade
dependence is, the more impact of exchange rate changes on the overall national economic is. Trade dependence countries are more
likely to choose the fixed exchange rate system.
The international exchange rate system reflects the power structure of international politics [3]. Internationally, changes of exchange
rate in main countries directly affect other international currencies in the foreign exchange market. Great powers seek certain
interests through exchange rate arrangements.
Firstly, it is necessary to reverse the country’s balance of trade, to maintain and enhance the confidence of local currency as an
international currency. Secondly, we need to bring about the internationalization and consolidate of home currency, thus get constant
Seignior age. Thirdly, is to keep its independence of monetary policy, and influence and even manipulate foreign policy.
①
In history, after the Bretton Woods conference, $35 equal to an ounce of gold, the dollar and gold, and other major currencies pegged to the dollar
again, this is essentially a system of fixed exchange rates.
②
The degree of trade dependence refers to the international trade accounted for the proportion of GDP.
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3.2 The choice of RMB exchange rate system
From 1994, China adopted a managed floating exchange rate system. After the 1997 Asian financial crisis, in order to prevent
financial risks, government further narrowed down exchange rate volatility. As a result, RMB became Pegging to the US dollar in
fact.
A Managed floating exchange rate system based on market supply and demand and reference currency basket has been operated
since 2005. With China’s rapid economic growth, RMB exchange rate issue has been focused.
In our country, economic development is facing big pressure. The growth speed has changed from rapid to slow and the vulnerability
of the economic growth increased. Secondly, export growth fell sharply; the trade deficit turn narrow, foreign exchange reserve
growth is slowing down. Thirdly, although current inflation still can be controlled, total trend is rising quickly.
In the last 10 years, China’s international balance of payments showed the current account and capital account surplus situation,
which resulted in the rapid unreasonable growth of foreign exchange reserves. Under the rapid increase in foreign exchange reserves,
the central bank put in a large amount of money which leads to rapid growth of foreign exchange, and increased domestic
inflationary pressure. Increasing in foreign exchange reserves formed an expectation of RMB appreciation. More and more
international speculative “hot money” flow into our country and increase the impact on our economy which easy to induce the
economic and financial instability.
Internationally, regional trade new framework is influencing the RMB exchange rate system. From the end of 2011, mainly in
developed countries, they have introduced a few pacts in a series of new area and agreement between their economic and trade,
investment, financial relations. The first is “trans-Pacific Partnership Agreement (TPP)”, second is “Transatlantic Trade and
Investment Partnership (TTIP)”, then “multilateral Services Agreement (PSA)”, and “the European Economic Partnership
agreement”. All these changed international monetary system and affected international economic and trade patterns.
In short, inside and outside boundary conditions of the choice of RMB exchange rate system has changed, China’s foreign exchange
management is faced with a dilemma condition. Therefore, the independence of monetary policy is limited.
4 Risk of Commercial Bank’s Exchange Rate
With the deepening reform of the RMB exchange rate regime and capital account liberalization, exchange rate volatility increased
and the frequency changed faster. Main problems in the exchange-rate risk management of commercial bank in our country are as
follows:
4.1 Risk of mismatching of foreign assets and liabilities in commercial bank
At present, much less attention has been focused on foreign exchange risk than credit risk and interest rate risk. Because exchange
rate fluctuation is modest and foreign business is a very small part of China’s commercial banks. However, commercial bank foreign
exchange assets and liabilities currency positions do not match, the sources of foreign exchange and the use of duration mismatch
will all lead to exchange rate risks. From the RMB exchange rate mechanism reform, commercial banks faced with big risk of
foreign currency exposure, high dollar allocation proportion and high risk of currency mismatch. [4] Exchange rate fluctuation may
reduce current earnings or economic value of the commercial bank when facing foreign currency exposure and maybe touch off
exchange rate risk. [5]
4.2 The risk of exchange rate fluctuations in capital
The system of our commercial bank capital consists of domestic and foreign currencies; the foreign currencies ratio reached fairly
high level. Under the influence of RMB exchange rate fluctuation, if there is a significant appreciation of RMB, capital of the
commercial bank may lead to shrinkage. This will undoubtedly have an adverse impact on the adequacy level of commercial bank
capital. At present, in addition to the capital adequacy ratio of state owned commercial banks remain at a high level, small and
medium-sized banks are near or below the supervision red line. [6]
4.3 Intermediate business risk of settlement and sales of foreign exchange in commercial banks
Increased frequency and amplitude of fluctuations in the exchange rate lead to worsen foreign exchange risk of foreign trade business
accounts which increased risk of commercial bank loans. Moreover, foreign exchange derivatives provided forms to avoid risk and
keep assets value. Meanwhile derivatives become speculative tools through their virtual and leverage properties. All This will
amplify risk, bring about tremendous challenges for exchange rate risk management of commercial banks in China. Losses of
enterprises might be converted into banks’ credit risks and losses.
4.4 The lack of perfect exchange rate risk identification and control system
For a long time, our commercial banks are mainly based on qualitative analysis, lack of quantitative analysis and insufficient
scientific on exchange rate risk identification, measurement and monitoring. Our banks are far behind advanced international banks
in the fields such as using statistical models in their daily risk management. Our Banks haven’t integrated risk value to daily risk
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management, such as product pricing and sales quota. Many commercial banks don’t have independent risk assessment system.
Especially they don’t have a system to effectively evaluate, track and monitor foreign exchange transactions, credit and other
important business risks.
5 The Innovation of Exchange Rate Risk Management of Commercial Banks
5.1 To further improve the risk management system of commercial banks
Sophisticated corporate governance structure is the basis of effective risk management. Commercial banks should formulate
long-term business strategy and clear risk management policies, business plan and management target. Commercial banks should
carry out multi-level risk management and risk management department should be managed closely and directly from top
management. In order to further improve the risk management systems of commercial banks, they should formulate effective
monitoring and clear risk management policies and procedures. Moreover, commercial banks should improve risk management
information system and establish capital allocation mechanism of appropriate market risk.
5.2 Improve innovation of foreign exchange risk identification, measurement and monitoring
Commercial banks ought to improve exchange rate risk identification, measurement and monitoring. During daily risk
management, overall and dynamic identification of exchange rate risk sources and manifestations should be tested by VAR, RAROC,
pressure testing and other advanced risk measurement tools and methods. And the foreign exchange risk exposure should be
accurately calculated. During learning of foreign banks’ advanced econometric models and methods, our banks should adjust and
develop more effective tools or models suiting for our banks’ requirements. Management and various departments could understand
exchange rate risk level and effectively control the risk of exchange rate by using specific quantified the exchange rate risk.
5.3 Constantly improve the exchange rate risk management innovation
Financial innovation is the main way to avoid or reduce the financial risks and protect the financial security. Commercial banks can
learn advanced management technology from foreign banks and establish a scientific regulatory system to control and manage the
exchange rate risk. Commercial banks should control and determine risk tolerance and risk limit through quota management and
hedging. Moreover, to keep exchange rate risks of financial innovation in a positive price range and constantly improve the quick
response ability to guard against and defuse financial risks.
5.4 To strengthen the risk management of financial innovation products
Commercial banks should make full use of financial derivatives to avoid the risk of the products and services for themselves and
other economic agents. When setting price for foreign exchange products such as foreign exchange loans, deposit, long-term
settlement and other foreign exchange derivatives, commercial banks should consider risks caused by different customers, different
tread team and different currencies. In addition, suitable diversified risk aversion tools should be developed such as foreign exchange
swaps, options and futures trading etc. In order to avoid exchange rate risk, active management mode should be use to meet customer
needs. At the same time, the risk classification and evaluation target should be strengthened. Mandatory information disclosure
system of financial innovation products should be enforced to maintain the dynamic coordination of financial business and product
innovation, in which can provide effective protection and promote financial security.
6 Conclusion
With the deepening reform of the RMB exchange rate regime, commercial banks faced with more difficulties in China. It is very
important to promote the financial innovation meanwhile strengthen risk control. It is needed to choose the exchange rate regime by
considering domestic economic-social development and financial stability. At present, there are several problems in exchange-rate
risk management in commercial banks, such as the risk of exchange rate fluctuations in capital, mismatching of foreign assets and
liabilities, lack of perfect exchange rate risk identification, control system and intermediate business risks. The authors provide
advices to improve the risk management and maintain financial stability, e.g. develop the risk management system, promote
innovation of foreign exchange risk identification and monitoring and strengthen the risk management of financial innovation
products.
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