BOK: Recent Sharp Exchange Rate Drop Has Reduced Banks’ Foreign Currency RWA by Up to 15% [Financial Stability Report]

Bank of Korea Releases Financial Stability Report

The recent sharp drop in the won-dollar exchange rate into the 1,300 won range over the past two months is estimated to have reduced banks’ foreign currency risk-weighted assets (RWA) by as much as 15%, according to some analyses. As a result, the capital buffer is projected to have risen by about 0.5 to 0.6 percentage points.

On September 22, the Bank of Korea stated in its Financial Stability Report that it reviewed the impact of recent exchange rate volatility on the financial sector and came to these estimates.

Fluctuations in the exchange rate affect banks’ financial standing through various channels. First, changes in the won conversion value of foreign currency assets and in credit RWA related to currency derivatives exposure both impact the overall size of RWA. This, in turn, affects banks’ capital adequacy ratios. In addition, banks’ net income is also affected by gains and losses from foreign exchange and currency derivatives.

According to the Bank of Korea, from the first quarter of 2022 to the second quarter of this year, the won-dollar exchange rate rose by 330.7 won, leading to a 51.3% increase in foreign currency RWA at domestic banks over that period. As a result, domestic banks faced downward pressure of 1.5 percentage points on their capital ratios. In the first quarter of this year as well, the unexpected surge in the exchange rate led to an expansion of foreign currency RWA, exerting a 0.46 percentage point downward pressure on the capital ratio compared to the end of the previous quarter.

However, the Bank of Korea expects that the burden on the banking sector has somewhat eased since July, as the exchange rate has fallen sharply. By accounting for reductions in foreign currency RWA during prior periods of falling exchange rates over the past five years, the Bank of Korea estimates that during the last two months, as the won-dollar exchange rate dropped by 165 won, foreign currency RWA could be reduced by approximately 9.3% to 15.4%.

It is also possible that capital pressures were partly alleviated in the third quarter. Looking at past periods of exchange rate declines, applying the rate drop in July and August of this year suggests that banks may have secured a capital buffer of roughly 0.5 to 0.6 percentage points.

The required margin payments related to currency derivatives, which tend to increase as the exchange rate rises, stood at 70% of the level seen during the 2022 Legoland incident as of the second quarter of this year, indicating domestic banks have maintained manageable levels. Accordingly, the liquidity coverage ratio (LCR) stayed robust at 114.0%, significantly above supervisory standards.

Meanwhile, securities companies’ financial soundness was only marginally affected by recent exchange rate volatility. Given that securities firms’ profits from foreign exchange and currency derivatives contracted during previous periods of sharp currency declines, continued drops in the exchange rate could further reduce such profits. However, since their aggregate foreign exchange risk exposure is not large and accounted for 3.4% of total risk exposure at the end of the second quarter this year, the Bank of Korea assessed that exchange rate fluctuations are not likely to have a significant impact on securities firms’ capital ratios.

Insurance companies also hold a substantial amount of foreign currency assets. However, since most positions are hedged through currency derivatives transactions, the Bank of Korea assessed that the impact of recent exchange rate volatility on these positions is largely neutral.

The Bank of Korea stated, “Although high exchange rates had persisted for a relatively long period and there was another significant increase in the first half of this year, the shock to the financial sector was less intense than during previous periods of rapid appreciation, thanks to the sound resilience of financial institutions. However, considering that volatility could expand again depending on future developments in the Middle East, the direction of international oil prices, and trends in key countries’ policy and government bond interest rates, it is necessary to maintain preparedness for uncertainty by securing both risk management and lending capacity.”

This content was produced with the assistance of AI translation services.