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Operations Manual

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OM Section 15: Issued on 12 December 1995
Foreign Exchange Risk in Bank Operations

Bank Policies (BP)

Introduction

1. According to Article 15.1 of the Bank's Articles of Agreement, the Bank does not assume the foreign exchange risk involved in its lending operations and requires that all repayments by its borrowers be made in the currency or currencies loaned.¹ During the time lag between disbursements and repayments of a Bank loan, foreign exchange risk for Bank borrowers arises from possible variations in the exchange rate(s) between:

(i) the foreign currency or currencies in which the loan is disbursed and repaid and other foreign currencies, and

(ii) the local currency and foreign currencies.

This OM Section deals with the question of attributing the foreign exchange risk associated with the Bank's lending operations. The assumption of foreign exchange risk in equity operations is also addressed.

Lending Operations

A. General Principles

1. Ordinary Capital Resources Loans

2. The type of foreign exchange risk noted in para. 1 (i) is affected by the specific currencies used by the Bank for disbursement. In contrast, the type of foreign exchange risk mentioned in para. 1 (ii) depends largely on the borrower's foreign exchange policy. The Bank treats differently the incidence of these two types of foreign exchange risk associated with its lending operations.

3. The Bank tries to ensure that the foreign exchange risk of its loans mentioned in para. 1 (i) above is not unduly excessive and that it is distributed as equitably as possible among all its borrowers. For this purpose, the Bank employs multiple ordinary capital resources (OCR) facilities: (i) an exchange risk pooling system, which is applied to all loans from its OCR, aiming at a more equitable distribution among borrowers of the foreign exchange risk arising from the disbursement of loans in various currencies; (ii) a pool-based multiple-currency variable lending rate system,² which replaced the fixed-rate Bank lending system; (iii) an additional OCR lending facility, pool-based but in a single currency, namely, US dollars. Borrowers can also avail of a market-based loan (MBL) window, limited initially to financial intermediaries in the public sector and to all borrowers in the private sector. The purpose of the MBL is three-fold: (i) to satisfy the growing demand for market-related lending instruments from financial intermediaries; (ii) to make the pricing of private sector loans more transparent by basing interest rates on such loans on the current costs of Bank borrowings; and (iii) to facilitate the matching of assets and liabilities in order to reduce the volatility of the Bank's income in private sector lending.

4. These multiple OCR facilities reflect, in part, the general concern of the Bank to reduce the uneven impact of exchange rate fluctuations on the Bank's borrowers, and to help improve risk management of borrowers' currency. These facilities do not affect the Bank's basic policy that the Bank shall not bear the foreign exchange risk in its lending operations.

5. The foreign exchange risk arising exclusively from changes in the borrower's local currency relative to other foreign currencies, mentioned in para. 1(ii) is entirely the responsibility of the borrower.

2. Asian Development Fund Loans

6. Loans from Asian Development Fund (ADF) resources are denominated in special drawing rights (SDRs) and, therefore, are subject to significantly less foreign exchange risk. Accordingly, the foregoing mechanisms applicable to OCR loans are not applicable to ADF loans.

B. Relending and Onlending

7. Special considerations are required when Bank loans are re-lent by the borrower to one or more beneficiaries, and particularly when they are on-lent by intermediaries (such as development finance institutions, commercial banks, and leasing companies) to subborrowers.

8. The Bank normally expects that the foreign exchange risk is passed on to the beneficiary. This may be achieved either directly through the beneficiary servicing the loan in foreign exchange or indirectly through reflecting the cost of bearing the risk in the relending rates charged to the beneficiary. When loan proceeds are on-lent by a financial intermediary (which may or may not be the borrower of the Bank's loan) to a number of subborrowers, the Bank requires that, as a matter of prudent banking practice, the intermediary should hedge the foreign exchange risk arising from the Bank loan. Generally, this risk should be passed on to subborrowers. The operational procedures of the development finance institution should, however, ensure that the risk assumed by the subborrower is adequately mitigated.

9. Regardless of who the borrower is, the Bank may agree to a government's assuming the foreign exchange risk, normally expecting the related cost to be shifted to the final beneficiary. In some developing member countries, the government may be willing to undertake the risk, and may charge beneficiaries or subborrowers a fee (usually by way of increased relending rates) to assure risk protection. As a matter of principle, a government subsidy of such costs should be avoided. However, in exceptional cases, the Bank may consider such subsidization, if warranted by country- and project-specific considerations.

Equity Operations

10. In contrast to lending operations, any foreign exchange risk arising in the context of the Bank's equity operations, such as investment in shares, units of a mutual fund, and underwriting commitments, is borne by the Bank.

Operational Procedures (OP)

This OM Section does not contain Operational Procedures.

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