Recommendation I on Foreign Exchange Risk Management in Banks and Rules for Conducting FX-Exposed Transactions

Recommendation I Page 1 of 11 Financial Supervision Commission Recommendation I concerning foreign exchange risk management in banks and rules for banks conducting transactions exposed to foreign exchange risk Warsaw, 2010

Recommendation I Page 2 of 11 I. Introduction This Recommendation replaces "Recommendation I of 2002 concerning foreign exchange risk management in banks and rules for banks conducting transactions exposed to foreign exchange risk." Foreign exchange risk, defined as exchange rate risk, is the danger of deterioration of the bank's financial situation due to unfavorable changes in exchange rates. In particular, it is associated with: • mismatch of appropriate asset and liability positions of the bank, the value of which is expressed in foreign currency, • concluded transactions, i.e., changes in exchange rates between the date of concluding the transaction and the date on which payment is received (exchange rate risk), • increase in other risks (e.g., credit risk) resulting from changes in the level of exchange rates.

II. Recommendations Recommendation 1: Responsibility for managing foreign exchange risk rests with the bank's governing bodies – the management board and the supervisory board. The supervisory board, in exercising its control functions regarding the risk management undertaken by the bank, approves the risk management strategy for the bank's activities developed by the management board. In doing so, the supervisory board should take into account, among other things, the occurrence of foreign exchange risk in the bank's activities. The supervisory board (or its specialized committees) should receive periodic information from the bank's management board presenting in a clear manner, within the given bank, a unified, synthetic, and understandable size of the foreign exchange risk to which the bank is exposed.

Recommendation 2: The management board of a bank in whose activities foreign exchange risk occurs should specify in the risk management strategy for the bank's activities the expected structure of turnover in transactions exposed to foreign exchange risk, the bank's planned position in the market for these transactions, the permissible degree of the bank's exposure to foreign exchange risk, and methods for monitoring it. The strategy for managing foreign exchange risk should be verified and updated at least once a year. More frequent verification should depend on the degree of the bank's exposure to exchange rate risk, changes in the scale of the bank's activities, and changes occurring in its environment. Periodic business development plans for transactions exposed to foreign exchange risk should be developed and updated based on the bank's long-term strategy of action.

Recommendation 3: The management board of a bank in whose activities foreign exchange risk occurs should include this risk component in the rules of conducting business and risk management by adopting and implementing rules for managing foreign exchange risk. Rules for managing foreign exchange risk should be consistent with applicable legal norms and supervisory regulations and coherent with the general rules for managing the risk of the bank's activities adopted by the bank.

Recommendation I Page 3 of 11 Recommendation 4: Rules for managing foreign exchange risk should include rules for analyzing transactions exposed to foreign exchange risk not only in terms of exchange rate risk, but also other risk components, such as in the case of transactions that do not carry foreign exchange risk.

Recommendation 5: Rules for managing foreign exchange risk should be prepared in writing and approved by the bank's management board. They should take into account the necessity of current foreign exchange risk management by banks preparing consolidated financial statements. Bank employees involved in the process of conducting transactions exposed to foreign exchange risk (excluding employees concluding deposit-credit transactions with clients from the non-financial sector) and employees managing foreign exchange risk should know these rules and apply them. Knowledge of the rules and their adoption for application should be confirmed by employees in writing.

Recommendation 6: Foreign exchange risk management should be performed by an appropriate team appointed for this purpose. This team may operate within an organizational unit responsible for managing various types of risk at the level of the entire bank. The task of managing foreign exchange risk may also be assigned to another team within the existing structures in the bank – in this case, however, it should be remembered to equip this team with the necessary powers to perform tasks in the field of managing foreign exchange risk at the bank level.

Recommendation 7: Rules for managing foreign exchange risk should provide for the creation of an appropriate organizational structure, a reporting system for the bank's management board and supervisory board, and effective risk management mechanisms through internal limits. Information provided to the management board regarding transactions exposed to foreign exchange risk should enable current monitoring of the impact of these transactions on financial results and monitoring of the foreign exchange risk borne by the bank, including compliance with internal limits.

Recommendation 8: The management board of a bank conducting transactions exposed to foreign exchange risk or applying for consent to conduct foreign exchange transactions should ensure the development in writing of internal regulations and procedures regarding their conduct, in accordance with legal norms and supervisory regulations. Regulations and procedures should be reviewed by the internal control unit. Introducing new products in the field of transactions exposed to foreign exchange risk should take place in accordance with the bank's procedure for introducing new products.

Recommendation 9: Adopted procedures for conducting transactions exposed to foreign exchange risk are an integral part of the rules for managing foreign exchange risk and should be consistent with these rules.

Recommendation I Page 4 of 11 Recommendation 10: The internal control system operating in the bank should take into account the occurrence of foreign exchange risk in the bank's activities. The internal control unit, after identifying areas requiring improvement, should inform other organizational units whose activities may be significantly dependent on the identified areas requiring improvement on a current basis. The bank's management board, during the periodic assessment of the functioning of the internal control system, should take into account, among other things, the issue of the usefulness of this system in the context of requirements for managing foreign exchange risk. A detailed discussion of the presented recommendations is contained in the Annex and takes the form of recommendations for banks conducting transactions exposed to foreign exchange risk.

Annex to Recommendation I Recommendations for banks conducting transactions exposed to foreign exchange risk

1. In the framework of planning the expansion or undertaking of activities in the field of transactions exposed to foreign exchange risk, the bank's management board should prepare and submit to the supervisory board of the bank for approval a report containing at least the following information: a) Proposals for introducing new types of transactions. b) Planned sizes of activities related to a given type of transaction, along with the indication of possible groups/categories of counterparties to whom the given product is addressed. c) Necessary organizational and technical changes related to the implementation of methods for identifying, monitoring, and controlling specific types of risk associated with transactions exposed to foreign exchange risk. d) Needs regarding the development of bank resources, including both personnel and technical means, so that at all times there is certainty that tasks facing the bank will be performed efficiently and safely, taking into account their nature and size. It is unacceptable for a bank to enter new areas of foreign exchange activity without appropriate preparation, including in particular: • conducting an assessment of risk associated with a new area of activity, • establishing limits for the new activity, • developing in writing detailed procedures, including accounting rules (in particular, rules for preparing, circulating, and controlling accounting documents and valuation rules) and reporting, • selecting personnel with appropriate qualifications and conducting necessary training.

2. The rules for managing foreign exchange risk adopted by the bank should take into account: a) Separation of units conducting transactions, units recording and settling transactions, and units managing risk.

Recommendation I Page 5 of 11 b) Establishment of the procedure for obtaining qualifications necessary for employees to perform transactions (e.g., courses, training, certificates) and the procedure for issuing employees authorizations to perform specific transactions. Authorizations should be issued in writing. c) Determination of the types of financial instruments on which bank employees may conclude transactions – lists should be created containing the following information: • a complete list of types of financial instruments along with their short description allowing for their unambiguous identification, • a complete list of branches, departments, teams, and individual employees authorized to conclude transactions with specific types of derivative instruments, • foreign exchange risk limits for individual employees, units, and organizational units of the bank or rules for limiting this risk at the bank level. d) Ensuring that employees responsible for monitoring compliance with exchange rate risk limits have: • access to current information on payments made, payments received, and payments in the course of being exposed to foreign exchange risk, and • access to current information on any delays in counterparties settling transactions, which involves exchange rate risk. e) Determination of rules for establishing limits for activities exposed to foreign exchange risk, resulting from the bank's policy on managing foreign exchange risk. f) Establishment and preparation in writing of procedures regarding the conclusion of transactions exposed to foreign exchange risk. g) Requirement to develop and implement recording rules within the scope resulting from the bank's internal needs and allowing for the preparation of required reports for external purposes, and to establish templates for internal reports. The bank should identify discrepancies between the measurement of foreign exchange positions resulting from accounting records and the measurement of foreign exchange positions resulting from records of operational units. h) Establishment, within the scope resulting from the bank's needs, of control requirements regarding concluded transactions, e.g., their verification, confirmation, independent valuation, and examination of unsettled transactions. i) Establishment of procedures for controlling individual stages of conducting transactions and current use and compliance with limits. The use of limits by units conducting transactions should be reconciled daily with records made by recording units. In case of discrepancies, until the cause of the discrepancy is identified, the data of the recording unit should be considered correct. j) Establishment of rules for making decisions in the manner provided for in the given bank (by the foreign exchange risk management team or by authorized employees) allowing for a one-time exceedance of a limit. k) Establishment and identification of sources of data on external and internal parameters related to the conclusion of transactions (including in particular the amount and variability of exchange rates). l) Establishment of rules for access to information within the scope resulting from the nature of decisions made at a given job position. m) Establishment of rules for the foreign exchange risk management team to make decisions in non-standard or crisis situations.

3. If the bank does not adopt different rules, it should be assumed that each organizational unit of the bank performing transactions exposed to foreign exchange risk should have written limits limiting the nature and size of a single transaction, with the condition that these limits cannot be set at a higher level than the respective limits for the higher-order unit and limits for the entire bank. Limits should be specified for individual currencies based on the nature, historical analysis of causes, and scale of disturbances in the value of the given currency, taking into account its future expected level estimated under conditions defined as bordering on high probability. All limits established by the bank should be binding. Any planned exceedances of them should be subject to prior acceptance by risk management personnel.

4. Foreign exchange risk burdening transactions indexed to foreign currencies is subject to the same restrictions and norms as foreign exchange risk burdening foreign exchange transactions.

5. The bank should have written rules for determining and monitoring the foreign exchange risk of structural positions.

6. Rules for managing foreign exchange risk, including foreign exchange risk limits, should result from the rules for managing the risk of the bank's activities adopted in the bank and should take into account the analysis of transactions in terms of their exposure to specific types of risk characteristic of banking activities, such as:

1. Exchange rate risk.
2. Credit risk.
3. Country risk.
4. Interest rate risk.
5. Liquidity risk.
6. Legal risk.
7. Operational risk.
8. Other types of risk identified by the bank as significant for the conducted activity.

7. Rules for managing each type of risk listed in paragraph 6 should include:

1. Measurement – unified and unambiguous rules for measuring a given type of risk, enabling aggregation at the bank level.
2. Reporting – determination of the form and deadlines for submitting internal reports on the level of risk, the detail and frequency of which should be adequate to the type and scale of the risk. The report should be available to appropriate employees in time for an appropriate reaction. It is also recommended to separate, depending on needs, a position (or team) dealing with controlling the correctness of submitted reports. This position should be organizationally independent from reporting services and have a defined procedure for informing the bank's authorities about identified or probable irregularities. The person or persons employed there should possess appropriate professional knowledge.
3. Limiting – determination of rules for establishing internal limits and indication of the unit or employees responsible for their establishment.
4. Management – indication of the unit or team of employees responsible for monitoring a given type of risk at the level of the entire bank, authorized to issue orders regarding limiting the risk undertaken by the bank, taking into account cases of a non-standard or crisis nature. This function should be separated from the function of managing foreign exchange risk at the operational level performed by employees of the treasury department.
5. Controlling – indication of the unit or employees responsible for examining the compliance of the activities of all bank units with internal and supervisory regulations, as well as for informing about identified irregularities.

8. Banks are recommended to establish and monitor internal foreign exchange risk limits, with the following conditions:

1. Internal limits should take into account restrictions for the risk of conducted activities resulting from supervisory regulations. They should also take into account forecasts of changes in exchange rates. The bank should prepare a forecast regarding the range of possible levels and variability of the exchange rate for each currency, limited by the lowest and highest exchange rate level along with the most probable exchange rate level. Based on this, the bank creates at least two scenarios regarding changes in exchange rates for each currency: one most probable and the second most unfavorable for the bank but still probable. This forecast and scenarios should be subject to regular updates. The frequency of updates should be adapted to the degree of changes in exchange rates.
2. In the case of using the Value at Risk (VaR) methodology for monitoring foreign exchange risk, it is recommended to take into account the following parameters: a) 10-day holding period for positions; if for operational purposes a different holding period is assumed, results should be appropriately recalculated (scaled) relative to time, b) at least annual period of trial (observation of historical data) – the choice of the length of the trial period should be made particularly carefully in terms of observed trends in exchange rate variability (the bank should create and update historical databases regarding exchange rates); this choice can also be supported by analysis of Value at Risk for selected sub-periods (e.g., the last few months), c) confidence level of 99% (assuming a one-sided confidence interval), d) Value at Risk should be calculated for each working day, e) results obtained using the Value at Risk methodology should be subject to continuous verification: • within historical verification (back testing) – by comparing them with actual losses in the field of transactions exposed to foreign exchange risk (daily), • within revaluation verification – by comparing them with hypothetical losses in the field of transactions exposed to foreign exchange risk (at least once a quarter). Additionally, when verifying the correctness of the applied Value at Risk model, particular attention should be paid to the occurrence of serial exceedances, i.e., the occurrence of an exceedance after an exceedance occurred on the previous day. This may indicate inappropriate selection of assumptions for the given model.
3. Monitoring foreign exchange risk should be an integral element of the bank's risk management system.
4. Banks with significant exposures to foreign exchange risk should have appropriate systems allowing for current monitoring of exposure to exchange rate risk, for the purpose of verifying compliance with established limits.
5. Banks in which the occurrence of foreign exchange risk is sporadic and insignificant from the bank's perspective may use simplified methodologies regarding internal rules for monitoring foreign exchange risk.

9. In the scope of credit risk associated with transactions exposed to foreign exchange risk, the bank should analyze balance sheet and off-balance sheet items burdened with this risk in the context of their impact on: a) the bank's solvency ratio, b) the burden on the credit risk limit at the level of individual portfolios, as well as at the level of individual clients, c) the creditworthiness of clients and the level of the LTV ratio (this ratio expresses the ratio of the amount of credit exposure to the value of collateral). It is recommended to adopt stricter rules for granting loans exposed to foreign exchange risk and to take into account the increased credit risk resulting from the possibility of an increase in the borrower's debt value due to the devaluation of the domestic currency. With regard to transactions other than credit transactions, the analysis should be made in division into pre-settlement risk and settlement risk, and for each of these categories into counterparty risk and product risk. As instruments for hedging the client's exchange rate risk*, the bank should primarily offer non-complex products and services, such as forward transactions or the client purchasing options. Offering more complex instruments, including option structures, should be limited to entities of the financial sector and to those clients who consciously wish to undertake exchange rate risk. The bank should have a list of counterparties with whom it may conduct transactions of value recognized by the bank as significant, establish internal limits of engagement towards a single counterparty for each category of clients. These limits must take into account applicable legal norms in this regard and limit the bank's engagement resulting from the settlement of transactions. The bank should have written procedures for the mode of conducting settlements with each category of counterparties, minimizing the risk borne. The bank should strive to identify the nature of the client's activity and their needs for hedging exchange rate risk or the desire to consciously undertake this risk in order to achieve financial benefits as a result of changes in exchange rates. Such information should also be periodically verified after the conclusion of the transaction. Before concluding a transaction, the bank should inform the client about potential obligations towards the bank arising in the case of significant changes in exchange rates. It is recommended to present clients with simulations of the impact of different-direction changes in exchange rates on the result of the hedged transaction and their credit risk.

10. In the scope of country risk, the bank should take into account the possibility of non-performance of obligations even by a highly reliable counterparty due to restrictions imposed by the central authorities of the counterparty's country on international settlements due to reasons related to the situation in the counterparty's country (e.g., internal unrest, catastrophes). In connection with this, the bank should determine limits on total engagement towards all counterparties from a country for which there is a risk.

11. In the scope of measuring interest rate risk associated with transactions exposed to foreign exchange risk, it is recommended that banks study the sensitivity of transactions exposed to foreign exchange risk to interest rate risk. Interest rate risk results, among other things, from mismatch of maturity/due dates, and in the case of transactions exposed to foreign exchange risk, it occurs even when the bank has a closed foreign exchange position. Calculation of the sensitivity of foreign exchange positions to changes in interest rates and determination of limits should be done for several expected future scenarios of interest rate changes. Detailed remarks in this regard are contained in the description of Recommendations 6 and 7 in Annex 1 to "Recommendation G concerning interest rate risk management in banks". Limits should be established taking into account calculated sensitivities and the level of losses accepted by the bank in the case of unfavorable changes in the exchange rate of a foreign currency.

12. In the scope of measuring and managing liquidity risk in foreign currencies, the bank should take into account the maturity and due dates of receivables and liabilities as well as forecasts of future inflows and outflows of foreign currencies. The forecast scenario should include the expected inflow and outflow of funds from specific categories of balance sheet and off-balance sheet items within a specified time. The bank should apply for these purposes the technique of assessing real cash flows indicated in Part III point B.2 of "Recommendation P concerning the system for monitoring the financial liquidity of banks". The bank should prepare at least two forecasts: one describing the most...