Banks taking big risks in forex, says Deutsche

LONDON (Reuters) - Banks are not doing enough to protect themselves against credit risks when trading foreign exchange with clients like hedge funds, according to Deutsche Bank's (DBKGn.DE) global head of foreign exchange.

The global credit crisis is highlighting the extent to which risk is not being adequately priced in the foreign exchange market, Zar Amrolia told Reuters.

Deutsche Bank is the world's biggest foreign exchange player, with a 21.7 percent share of the $175 trillion yearly interbank FX market in 2007 according to Euromoney magazine's latest survey.

Amrolia said that banks which lend to hedge fund clients and allow them to trade on their book through prime brokerage arrangements often don't demand enough collateral to protect them from losses should things go wrong.

Prime brokerage is the arm of an investment bank that lends to hedge funds to make speculative trades.

Amrolia said some major banks do not demand upfront collateral when accepting trades from hedge fund clients. Instead they just expect any losses accrued to be settled on a daily basis.

"When the client owes the bank money they typically post collateral, so you have 'no credit exposure'. If everything happened instantaneously it would be fine," Amrolia said.

"But if your positions are $10 million under water at the close of play and you post that margin but when the markets move the next day and you're down $15 million and they are bankrupt, you don't have that $5 million - that's the gap risk the prime brokerage bank could have."

The credit crunch which started last year has led investment banks to rein in the amount they are prepared to lend, pushing up interest rates and forcing central banks to pump liquidity into global financial markets.

He added that the sheer intensity of trading is increasing difficulties for banks struggling to keep up with the frenetic activity in the overall $3.2 trillion-a-day market.

"The credit crunch has created both opportunities and stresses in the foreign exchange business," Amrolia said.

"There are some players where the systems and processing systems are in times of stress less successful. When things move around a lot, the way options books are run really needs to be looked at."

However, he said Deutsche Bank had benefited from the volatility.

Growth from its emerging market business was particularly strong.

"In the West earnings seem to be under pressure. That really hasn't spilled over outside the financial industry to the real emerging market currencies," he said.

"So corporate earnings in India, Brazil ... are in good shape, so they are doing more business."

(Editing by David Christian-Edwards)