Settlement Risk in Foreign Exchange Transactions

Abstract

Each day huge amounts of money are transferred between financial institutions around the world as settlement for foreign exchange (FX) transactions. Owing to time zones and technological limitations, parties to settlement transactions normally assume full and unsecured risk with regard to counterparty exposure. A bank’s risk exposure for each transaction often lasts for as long as 48 hours, sometimes entailing credit risk against certain counterparties which exceeds the bank’s equity. The central banks of the G-10 countries have for many years worked to induce participants to take steps to contain this risk. Banking crises and political unrest can spread through FX settlement risk, which may inflict considerable losses on Norwegian banks and jeopardise financial stability. Norges Bank has recently conducted a survey of FX settlement risk in Norwegian banks, modelled on analyses for the G-10 countries. The survey showed that the bulk of the volume is under acceptable control, but that there is still considerable room for improvement.