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Abstract
After the adoption of International Convergence of Capital Measurement and Capital Standards (widely known as Basel II requirements) in 2004 the risk management in commercial banks has changed dramatically. Lithuanian commercial banks are in transitional period now adapting their risk management systems to Basel II requirements. Market risk is considered one of the key risks in bank risk management structure, so proper management of market risk is essential for a modern bank. Currency exchange risk usually is the main component of market risk. Currency exchange risk management in Lithuanian commercial banks was not good enough; also the Central Bank's regulatory limits were liberal. But after the adoption of Basel II requirements, the entire risk management system is transforming and currency exchange risk management is affected. The objective of this paper is to demonstrate the transformations of currency exchange in Lithuanian commercial banks and propose an effective model for commercial banking. These transformations are performed in the regulatory system imposed by the Central Bank of Lithuania and through transformations of the bank's internal risk management system moving to internal (usually VaR based) models. VaR models are considered as modern methods for risk management. These models proposed by Central bank or other authorities for internal and statutory risk management in commercial banks. In this article, the proposed variation‐covariation VaR model was tested with real data using the back‐testing method. Back‐testing showed that the proposed model is reliable enough, because the number of mismatches was less than 5 % in all tested currency pairs during all testing. In most currency pairs mismatches percentage was lower than 3 %. Back‐testing results confirm that the VaR method is reliable enough for day‐to‐day using by financial institutions and traders.
Highlights
Risk management approaches in commercial banks were changing when first commercial bank started its activities
The Basel Committee began to address the treatment of market risks in a 1993 consultative document, and the outcome was the 1996 Amendment of Basel 118 to be implemented by international banks by 1998 [8]
Basel committee and the Central Bank of Lithuania has certain specific requirements to be satisfied for good VaR model [11]: 1. Bank models must compute VaR on a daily basis
Summary
Risk management approaches in commercial banks were changing when first commercial bank started its activities. For banks where intermediation is the principal function, risk management consists largely of good asset–liability management. Such banking (and risk management) approaches were very important up to the 1980s. Main international banks regulator is Basel Committee, which issues guidance for central banks how to control commercial banks and for commercial banks how to manage risk and banking activities. Lithuania central bank already trying to enforce commercial banks use modern risk management (mostly VaR based) models for internal or external (reporting) purposes. The goal of the research is to describe currency risk management transition in Lithuanian commercial banks and propose the VaR model for currency risk management in financial institution. The object of the research is currency risk and currency risk management
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