CREDIT RISK

 Credit risk, inherent in all banking activities, arises from the possibility that the counterparty to a contract cannot or will not make the agreed payment at maturity. When an institution provides credit, whatever the form, it expects to be repaid. When a bank or other dealing institution enters a foreign exchange contract, it faces a risk that the counterparty will not perform according to the provisions of the contract. Between the time of the deal and the time of the settlement, be it a matter of hours, days, or months, there is an extension of credit by both parties and an acceptance of credit risk by the banks or other financial institutions involved. As in the case of market risk, credit risk is one of the fundamental risks to be monitored and controlled in foreign exchange trading. In banking, the reasons a counterparty may be unwilling or unable to fulfill its contractual obligations are manifold.There are cases when a corporate customer enters bankruptcy, or a bank counterparty becomes insolvent, or foreign exchange or other controls imposed by governmental authorities prohibit payment. If a counterparty fails before the trade falls due for settlement (pre-settlement risk), the bank’s position is unbalanced and the bank is exposed to loss for any changes in the exchange rate that have occurred since the contract was originated. To restore its position, the bank will need to arrange a new transaction, and very likely at an adverse exchange rate, since no one defaults on a contract that yields positive gains. In situations of bankruptcy, a trustee for the bankrupt company will endeavor to “cherry pick,” or perform according to the terms on those contracts that are advantageous to the bankrupt party, while disclaiming those that are disadvantageous. In foreign exchange trading, banks have long been accustomed to dealing with the broad and pervasive problem of credit risk. “Know your customer” is a cardinal rule and credit limits or dealing limits are set for each counterparty—presumably after careful study of the counterparty’s creditworthiness—and adjusted in response to changes in financial circumstances. Over the past decade or so, banks have become willing to consider “margin trading” when a client requires a dealing limit larger than the bank is prepared to provide. Under this arrangement, the client places a certain amount of collateral with the bank and can then trade much larger amounts. This practice often is used with leveraged and hedge funds.Also,most institutions place separate limits on the value of contracts that mature in a single day with a single customer, and some restrict dealings with certain customers to spot only, unless there are compensating balances. A bank’s procedures for evaluating credit risk and controlling exposure are reviewed by bank supervisory authorities as part of the regular

CREDIT RISK