The Monetary Board increased the market risk weight of Non-Deliverable Forwards (NDFs) to reflect the potential systemic risk from NDFs transactions as a result of the increased volatility in the foreign exchange markets.
The Board took this initiative as a macro-prudential policy move. Macro-prudential measures pertain to those that are geared primarily to preserve overall financial stability as opposed to re-enforcing the safety and soundness of individual institutions which remain well-capitalized at present. NDFs can be effective hedging instruments for those who may not have sufficient foreign exchange assets to settle their future foreign exchange obligations. However, in a situation where the market has increasingly taken a one-way view that the Philippine peso (PHP) will strengthen over time, NDFs also became attractive vehicles for speculative funding flows.
This latest move by the Monetary Board is a pre-emptive measure signaling against those using NDFs for speculative purposes which could be de-stabilizing should market conditions reverse quickly. The approach to deploy the risk-based capital mechanism to discourage undue speculation is considered more equitable, incentive compatible, and market-friendly than outright prohibition or arbitrary caps.
Governor Amando M. Tetangco, Jr. made clear that "the BSP continues to firmly support those who need to hedge legitimate foreign exchange exposures". However, the Governor added that "we [in the BSP] are also cognizant that speculators have been attracted to NDFs as a money market instrument and for that reason, we need to put in place pro-active and prudential measures. This is a calibrated and proportionate response.”
BSP data show that NDFs have been rising but outright forward transactions have declined. This reinforces the view that there is more to NDF activity than just an intention to hedge. With market trends still vulnerable to the on-going macro-financial difficulties in Europe and in the United States, NDF exposures pose heightened market risk from the market's volatility.
On three separate occasions this year, the market had voluntarily set limits on banks’ net open NDF positions. The BSP had publicly welcomed the initiative of market players to contain the growth of the NDF market but believes that the aspect of system-wide risk needs more explicit regulatory treatment.
"The voluntary limits only address the volume of the exposure but do not yet address the potential ramifications when trends in foreign exchange rates reverse", the Governor pointed out.
"The gains and losses from trades are a private matter between counterparties. But these gains and losses have consequences on market volatility, difficulties in closing out forex liabilities and even the safety and soundness of banks, among others. These are definitely issues of public policy and regulatory oversight", the Governor added.
Under the standardized approach for calculating capital adequacy, the outstanding balances of instruments which are dependent upon market rates are multiplied by assigned risk weights. Summing the product across all related instruments will generate the market risk component of the Capital Adequacy Ratio (CAR).
Currently, the net open position of NDFs carries a market risk capital charge consistent with a CAR of 10%. Under the new measure, NDFs will be assigned a higher risk weight equivalent to a CAR of 15% for this specific instrument.
To ensure an orderly transition to the new capital charge and to allow modifications in the BSP template for calculating CAR, the higher weights will apply to the net open position of NDFs on 01 January 2012.