Concerns Over Exchange Rate Volatility Persist... Financial Firms Should Flexibly Manage Liquidity Regulations

Bank of Korea Financial Stability Report

The Bank of Korea emphasized the need for proactive measures, such as flexibly managing capital ratio and liquidity ratio regulations for financial institutions, to prevent the increased volatility of the won-dollar exchange rate from leading to liquidity shortages in financial institutions.

On the 22nd, the Bank of Korea analyzed the risk transmission channels and impacts of exchange rates on the financial sector through its Financial Stability Report. This year, the won-dollar exchange rate rose rapidly due to the Federal Reserve's (Fed) tightening monetary policy stance, maintaining a high level continuously from September to November.

This sharp rise in the won-dollar exchange rate, combined with recent financial market instability, has intensified negative spillover effects. For domestic banks, an increase in the exchange rate causes the won value of foreign currency assets to rise and requires additional margin payments for over-the-counter derivatives transactions, which act as factors lowering domestic banks' capital ratios and liquidity coverage ratios (LCR).

From the third quarter of last year, when the total capital ratio showed a downward trend, through the third quarter of this year, the rise in the exchange rate and the increase in foreign currency risk-weighted assets lowered domestic banks' total capital ratio by 1.35 percentage points. Additionally, the decrease in high-quality liquid assets due to additional margin payments in September reduced the LCR by 1.28 percentage points.

For non-bank financial institutions such as securities firms and insurance companies, due to their market-based funding and operational structure characteristics, exchange rate increases mainly affected won and foreign currency liquidity rather than capital ratios. A sharp rise in the exchange rate contracts banks' swap transactions, increasing the rollover risk of swap transactions in the non-bank sector, while rising hedging costs and additional collateral payments for over-the-counter derivatives increase won liquidity risk for insurance companies.

The Bank of Korea stressed the need for proactive measures to prevent the deepening volatility of the exchange rate from spreading into liquidity shortages in the domestic financial market, especially as the impact of exchange rates on financial institutions' financial ratios has significantly expanded compared to the past.

The Bank of Korea explained, "Policy authorities need to flexibly manage capital ratios and liquidity ratios according to market conditions during sharp exchange rate fluctuations, rather than rigidly controlling them, to prevent stress situations from escalating into crises," and added, "financial institutions should also pay close attention to risk management to prevent mismatches in maturity and liquidity between foreign currency assets and liabilities from expanding."

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