UK Regulator Seeks to Remove Structural FX Trades from Basel Calculation

The UK’s Prudential Regulatory Authority (PRA) has published a consultation paper seeking industry feedback on proposals to exempt structural FX trades – that hedge specific business risks – from Basel III calculations.

Observing that firms may hold assets, liabilities, or capital resources in currencies other than the reporting currency of the institution, the PRA says, subject to certain accounting requirements, these positions may be held on the balance sheet, valued using the exchange rate at the time of acquisition (so-called historical cost, or historical FX rates).

“The accounting value of such positions would generally not be updated frequently, and the FX risk arises in a different way, under different circumstances, than when positions revalue more frequently,” the PRA states. “The PRA proposes to clarify that positions held at historical FX rates in accordance with the relevant accounting principles are not to be included in the net risk position calculated.”

That said, the PRA adds that it believes firms should take into account, and where necessary capitalise, the contingent FX risk arising from these positions.

Arguing that its approach is “prudent and proportional”, the PRA says the proposal will apply to all market risk calculation approaches, including the Simplified Standardised Approach (SSA), the Advanced Standardised Approach (ASA) and the Internal Model Approach (IMA).

“Positions held at historical FX rates do not typically affect capital ratios,” the PRA argues. “Thus introducing them in the Pillar 1 FX risk calculations could distort firms’ hedging incentives, leading to potentially higher capital volatility.

“Several of the proposed new market risk methodologies use a sensitivity-based approach to risk calculation,” it continues. “Applying a sensitivity-based approach to positions which do not revalue frequently, and hence are not sensitive to movement in FX rates, may lead to a gap between the risk faced by firms, and the risk estimation in the capital framework.

“The PRA considers it is proportionate and transparent to provide clarity on risk estimation for positions that do not revalue frequently,” it adds.

The closing date for the consultation over the proposals, which are targeted to come into effect on 1 January 2025, is 31 January 2024.

The full consultation can be accessed here.