The notion of the world has greatly shifted from being a large sphere to a global village as communication and travel channels continue to improve making access of places and exchange of information fast. This has necessitated conducting businesses on an international level and on the center stages of this, are the banks which are viewed as the focal point of business as well as the economy. As a result, banks in the United States have captured this opportunity and have gone further to establish branches as well as to invest in foreign countries so as to increase their revenue. However the issue of foreign exchange rates has been the major challenge affecting commercial banking in the United States. This paper examines the issues surrounding the foreign exchange policies as well as the extent to which they affect the performance of commercial banking both internally and externally.
Foreign Exchange Rate
It is of uttermost importance to understand the parameters of foreign exchange in order as to get a clear understanding of the influence they have on commercial banking. Foreign exchange rate is simply the exchange value of the dollar with the local currencies in the foreign countries. The value during buying differs from that of selling the dollar. The exchange rate of the dollar with these currencies is never constant considering the fact that in the modern world business is conducted on a free market.
The value of exchange depends on various factors varying from the internal factors that only affect a given country to some factors that are global in nature. These factors include political and economic stability of a country and international acts among others.
The Risk of Foreign Exchange
As United States banks continue to expand their business deals on an international scale, the banks continue experiencing the risks that are involved in this kind of business expansion. Due to the fluctuations involved in the foreign exchange rates, the amount of revenues received by a bank cans shift in a very big way. This is particularly the case for those banks that have either assets and at times liabilities or both, in foreign countries. Since the rates of foreign exchange are highly unpredictable, there is always a risk as far as business deals in foreign countries is concerned.
The best that can be done in this case is prediction of estimates of the extent of fluctuation in the exchange rates. However, these are just predictions and from past experience the rates have not always been as expected but have shifted either downwards or upwards and thereby with complete disregard to the estimates. Banks incur transactional as well as translational risks. The risks in the category called transactional arise as a result of unfavorable exchange rates that may result to losses. On the other hand, the other type of risks called translational risks may arise due to the risks on accounting involved in the translation of assets held by these banks abroad in foreign currencies.
The Risks Posed on Commercial Banks
From the time commercial banks in the United States began to venture more into the international markets, they had to deal with the eminent risks posed by their venture. An examination into the source of these risks reveals that they emerge from both the trading part of business as well as the non-trade engagements (Naved, Ijaz & Anjum 212).
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The trading activities involve buying as well as selling of foreign currencies in order to accomplish various transactions. Some of the reasons for buying and selling of foreign currencies include a general interest to allow international trade by the various customers of these banks to take place freely and easily (Naved, Ijaz & Anjum 252). These banks also involve themselves in the risky exchange of currency with other countries siting an increase of foreign investment by their customers. This is because foreign investments involve large sums of money and can only be made efficiently through the mechanism of foreign exchange. Through engaging in these risks of buying and selling of foreign currencies on behalf of their customers, these banks act as agencies.
Other than the above mentioned reasons, commercial banks also engage in the sale and purchase of foreign currencies for purposes of hedging in a bid to cover the exposure of customers to foreign currencies and also as a result of different future predictions by financial experts on the expected trends of the rates of foreign exchange. This kind of risk may either result in profit or loss making depending on the outcome of the prediction.
Other than trade risks that these commercial banks have to bear, the bank also faces some non-trade risks as it continues to venture into the various foreign markets. These types of risks are usually a result of the various principles of banking that are related to banking contracts (Sercu, Piet & Raman 78). These types of contract risks include the ready, the spot as well as the swap and forward contracts. However, banking services as well as products are the chief non-trade risks associated with foreign exchange.
U.S. Commercial Banks Exposure to Foreign Currency
According to a research by Sercu, Piet & Raman, the risk posed by the fluctuations foreign exchange rates to commercial banks is determined by the net worth of these banks. These risks are mainly as a result of a bank operating from an unhedged position. A bank can also get into this type of risk known as the FX risk by selling more of the foreign currency such that the value sold surpasses the value of the purchased risks. This kind of a transaction is termed as the Net Short. On the other hand, the bank can get into another position known as the Net Long by purchasing more foreign currencies and thus surpassing the currency purchased (Sercu, Piet & Raman 98).
Both the Net Short as well as the Net Long positions are major causes of risks to the commercial banks in the United States. These two positions are a cause of worry to many commercial banks as a result of the fluctuations associated with the foreign exchange rates. The fluctuation may act as an advantage to the banks in the case where they result to making of profit and a nightmare to these banks in the cases where the net result is making of losses. Provided that the foreign currency fluctuates in value as compared to the U.S. dollar, then the bank stands to make losses depending on the amount of money invested. This happens when the commercial bank is in a position of Net Long. Also, the United States banks may incur major financial losses while in the Net Short position. According to a research by Hogan and Sharpe, these takes place in a case where there is a rise in the value of the foreign currency as compared to the United State dollar (Hogan & Sharpe 315).
Importance of the Volatility of the Exchange Rates
The volatility of the exchange rates is normally used to measure the extent of the fluctuation of the exchange rate over a given period of time. Volatility increases if there is a high fluctuation of the exchange rate over a certain period of time. On the other hand, volatility is said to be low in cases where the fluctuation of the exchange rate between the United States dollar and other foreign currencies is low within a given period of time.
Methods Employed to Eliminate the Risks
The fluctuations in the exchange rates have prompted commercial banks to seek solutions that will assist them in minimizing the negative effects brought about by these fluctuations. This has been necessitude due to the adverse effects known to be brought about by these fluctuations. In some occasions, the fluctuation of foreign exchange rates has been the cause of the closure of many banks. This has been brought about by huge losses incurred by some banks leading to closure. The huge looses may also lead to banks being declared bankrupt, and thus leading to their closure.
The occurrence of this situation is very rare in modern days as compared to the past. However, the possibility of such an event cannot be taken lightly. From past experience, such an event can lead to a public outcry as many people lose their savings and as well their life-long interments. The result may be widespread chaos and demonstrations that may result in political instability as wells a collapse of the economy. It is for this reason that banks have seen the need to seek several reasonale and functional solutions to minimize the threats posed by fluctuations of foreign exchange rates.
One of the methods employed by banks is hedging. Basically, hedging is a method used by banks to eliminate risks brought about by fluctuating exchange risks (Hogan & Ian 354). There are different methods through which hedging can be done. One of these methods is by matching the assets and the liabilities of bank that are in foreign currencies. This is done so as to ensure that the positive profit is spread without focusing so much on the fluctuations of the rates. The spread of the positive profit at maturity of the liabilities and assets will ensure that the fluctuating exchange rates do not affect the cost of exchange.
A bank can also use the derivative form of hedging such as the forwarding of foreign currency contracts which never appear in anywhere in the bank’s balance sheet. And finally the bank can perform hedging by diversifying its foreign liabilities and assets. This helps to reduce risks as well as to reduce the capital cost.
The participation of banks in the foreign market has greatly improved the revenue of commercial banks in the US. However the fluctuation of the rates of foreign exchange has posed real risks o international business. These risks are known to because by both the trade and the non-trade business engagements. Most of the trade engagements involve the buying and selling of foreign currency. The non-trade engagements that result to foreign exchange risks mainly involve the signing of different contracts. The US banks are exposed to foreign exchange risks when they engage in exchanges that put then on two different position that include the Net Short and the Net Long. The measure of volatility is an important part of predicting future trends of exchange rates. The banks have south and found some methods to deal with the ever present risks of fluctuating foreign exchange rates. The best method used by banks to eliminate risks is the concept of hedging.
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