New Basel credit-exposure limits will force banks to think harder on concentration

By Guest Contributor
April 10, 2013

By Bora Yagiz, Compliance Complete

NEW YORK, Apr. 9 (Thomson Reuters Accelus) - The Basel Committee’s March 26 plan on the supervisory framework for measuring and controlling large exposures is offering a new insight into how internationally active banks should determine their level of exposures to a single counterparty and a group of connected counterparties, and which factors they should weigh in making the necessary calculations.

The proposed framework recognizes for the first time that no form of concentration risk has been considered in the previous calculation of capital requirements. It, therefore, considers a large exposures framework to be complementing the Committee’s work on risk-based capital standards, which by themselves do not take into account the possibility of large losses due to concentration risk.

The Committee is soliciting comments from the public on the issue until June 28, 2013. The rules, once finalized, would come into force in 2019.

The Basel Committee issued its first guidance on credit exposures in 1991, which the committee followed up with a document entitled Core Principles for Effective Banking Supervision in 2012 as part of a wider goal in setting a minimum standard for sound prudential regulation and supervision of banking systems.

The 1991 documents can be considered to be the first to tackle the definition of credit exposure, taking into account the standard forms of lending as well as contingent requirements and obligations off-balance sheet. It set a 25-percent capital limit on the consolidated private sector non-bank exposures of a banking group, and emphasized the increasing interconnectedness of the industry.

The latter document leaves the setting of bank exposure limits to counterparties largely to the discretion of supervisors.

In putting together the new framework, the Basel Committee has taken stock of both the instrument-based contagions originating from exposures to certain types of asset classes (such as asset-backed securities and collateralized debt obligations) and the institution-based contagions emanating from direct exposure of numerous systemically important institutions (SIFI) to a particular company (as in the AIG debacle during the recent financial crisis).

The committee intends to build upon the earlier documents by setting more concrete rules and stringent limits in credit exposures, in an attempt to bridge the gaps between different exposure calculations and bring uniformity to the definition of capital and credit risk mitigation techniques across various jurisdictions.

Under the new proposed standards, the exposure limit of one SIFI to another is projected to be lowered to 10 percent to 15 percent of eligible capital. This is a more stringent limit, with qualitative and quantitative impact. Not only does the framework provide for a numerical reduction from the existing 25 percent limit, but it also considers the eligible capital to be based on the narrower definition of common equity capital, rather than total capital.

Since the financial crisis, the Basel Committee has restricted the definition of common equity capital to the highest quality of asset classes. It is primarily composed of common equity, and excludes or phases out debt-like instruments such as deferred tax assets and trust preferred securities.

The committee also proposes to establish a relatively low threshold of 5 percent of a bank’s eligible capital base to any counterparty for regulatory reporting purposes, in order to alert supervisors to potential risk areas and encourage them to investigate issues further if needed.

The exposure framework includes non-derivative assets, off-balance sheet commitments, and positions in the trading book with values based on the mark-to-market approach for calculation purposes.

The Basel Committee seeks an exposure calculation standard that is as conservative, simple and consistent as possible, with the intention that the standard serves as a simple backstop measure to limit the maximum possible loss that a bank could incur in case counterparties were to fail.

To this extent, the Committee suggests a 100 percent of credit conversion factor for the off-balance sheet commitments. This assumes that the failing counterparty would draw on any funds available when faced with failure the institution, and implies that the institution with the exposure would be liable for the entire credit risk.

Similarly, to keep uniformity across banks, credit risk mitigation techniques would be applicable only within the framework of the standardized approachh risk-based capital rules. And, while a hybrid approach is proposed for the treatment of financial collateral under the gcomprehensive approach, the framework encourages banks to use supervisory haircuts rather than apply values generated by their own internal models. Indeed, internal models are generally discouraged throughout the document.

Furthermore, factors such as probability of default, and potential recovery values are discredited by the framework because the Committee presumably believes that such factors can be subjective and difficult to estimate.

The committee remains mindful of potential significant operational costs, and shies away from making specific requirements, which allows a fair amount of flexibility. For example, while the committee differentiates between those banks using the internal ratings-based approach in calculating their exposure gross of specific provisions and value adjustments, and those using the standardized approach on a net basis, it recognizes that a switch in calculation methodologies could be unnecessarily burdensome.

Divergence from Dodd-Frank prudential rules

The proposed new standards diverge in certain aspects from the enhanced prudential rules of Dodd-Frank Act proposed in 2011 that already provide guidance on single counterparty credit concentration limits for bank holding companies with $50 billion or more in assets and all FSOC designated nonbanks, known as covered companies in the U.S., says Charles Horn, an attorney with Morrison Foerster.

Indeed, a proposed rule, by the Federal Reserve that offers a comprehensive framework of enhanced prudential for financial institutions (including banks) brings additional complication to the issue.

The proposed rule in question would prohibit covered companies with $500 billion or more in assets from having a credit exposure to any unaffiliated company in excess of 25 percent of the covered company’s capital stock and surplus, which is calculated as the company’s total regulatory capital and its excess loan loss reserves. This is significantly more lax than the proposed Basel standards.

The rule would also allow covered entities to reduce their gnet credit exposureh more liberally than is provided under the Basel proposed framework through credit risk mitigation techniques such as netting agreements for certain types of transactions, most forms of collateral, guarantees, and other forms of credit protection.

The proposed rule was met with skepticism by banks and banking associations. Specifically, a study by The Clearing House warned that the current exposure methodology suggested by the agency would overstate derivatives counterparty exposures, as it would not take into account the bi-lateral netting agreements, the use of collateral in securing the daily marked-to-market current credit exposures of derivatives, and the diversification that exists in many portfolios of derivatives contracts. This, the study contended, may cause markets to experience liquidity problems as banks would be forced to scale down their credit intermediation and market making activities in order to stay within the exposure limits.

While certain areas of the proposed rule such as stress testing, capital and liquidity requirements have been finalized since the proposal came out in January 2012, no similar progress has been made, however, regarding the credit exposure limits.

Challenges ahead 

In light of the new guidance provided by the BIS and numerous scandals that marred the banking industry since early 2012, U.S. regulators will be under pressure to revise their proposals in the coming months. Banks may, therefore, have to buckle up for stricter credit exposure limits.

These new rules introduced would mean that the banks would experience a significant impact on their financial exposures and balance sheet management activities. Critically, they would also have to struggle with the process of identifying, calculating and aggregating multiple exposures across a range of banking and nonbanking businesses that ultimately will present operational challenges.

The main challenge will, however, be for the regulators. As Mayra Rodriguez Valladares, Managing Principal at MRV Associates put it, ”with their limited resources, it will be difficult for them to monitor all banks’ types of on- and off-balance sheet activities recorded in banking and trading books across different jurisdictions”.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus (http://accelus.thomsonreuters.com/). Compliance Complete (http://accelus.thomsonreuters.com/solutions/regulatory-intelligence/compliance-complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges. Follow Accelus compliance news on Twitter at: http://twitter.com/GRC_Accelus)

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