Foreign exchange lending risk
Institutions should take into account that foreign exchange lending risk:
may arise from the unhedged borrower’s (i.e. retail and as small and medium-sized enterprise-SME borrowers without a natural or financial hedge that are exposed to a currency mismatch between the loan currency and the hedge currency, as defined in EBA/GL/2014/13) inability to service debt denominated in currencies other than the currency of the Member State in which the institution has been authorised;
is related to pure credit and foreign exchange market risk;
is characterised by a non-linear relationship of credit and foreign exchange market risk components;
is influenced by the general exchange rate risk; and
may arise from conduct-related risk.
In their stress testing programmes, institutions should take into account foreign exchange lending risk affecting credit facilities in the asset side of their balance sheet and its multiple sources of risk, taking into account that the debtor’s inability to repay its debt may originate from:
Institutions should consider, when designing or implementing their stress test scenarios, that foreign exchange lending risk impacts may arise from the increase in both the outstanding value of debt and the flow of payments to service such debt, as well as an increase in the outstanding value of debt compared with the value of collateral assets denominated in the domestic currency.
Institutions should develop stress scenarios by changing different parameters to allow them to forecast foreign exchange credit portfolio performances in different cases, such as:
In order to assess potential vulnerability, institutions should be able to demonstrate additional credit risk losses stemming from foreign exchange lending risk separate from the credit risk losses and risk exposure amounts resulting from the impact of the scenario on credit risk factors.
When stress testing the foreign exchange lending risk, institutions should take into account at least:
the type of exchange rate regime and how this could impact on the evolution of the foreign exchange rate between domestic and foreign currencies;
the sensitivity impact of exchange rate movements on a borrower’s credit rating/score and debt servicing capacity;
the potential concentration of lending activity in a single foreign currency or in a limited number of highly correlated foreign currencies;
the potential concentration of lending activity in some specific sectors of the economy, in the country currency, that have a core business in foreign currency countries or markets and the corresponding evolution of such sectors highly correlated with foreign currencies; and
the ability to secure financing for this type of portfolio; for institutions applying internal models for the calculation of credit risk capital requirements, the additional risk related to lending in foreign exchange currencies should be reflected in higher risk weights of such assets, and the non-exhaustive list of variables used in the models should include interest rates disparities, loan-to-value (LTV) ratios, currency cross correlation and volatility.
Institutions should take into account possible significant weaknesses that may be built into internal models with a possible underestimation of currency depreciation in relation to the client’s ability to service its debt, taking into account the following indicative elements:
monetary policies during a crisis period are often focused on stimulating the real economy by significantly decreasing reference interest rates, with potentially misleading information from internal models regarding these indirect effects; and
currency appreciation may be partially offset by falling interest rates and this may cause an underestimation of risk related to foreign exchange lending because, in zero interest rate environments, such a trade-off may not be possible in the long term.
While assessing the potential impact of foreign exchange lending on profitability in a certain scenario, institutions should, where appropriate, include the legal regime and the relevant jurisdiction, which may force institutions to denominate foreign exchange lending in the domestic currency at exchange rates significantly below market ones.