Review of the Basel Committee's "Supervisory framework for measuring and controlling large exposures"

The Basel Committee on Banking Supervision is looking to create global limits on bank exposures and has published a consultative document outlining their thoughts and asking for comments. The document is “Supervisory framework for measuring and controlling large exposures”. We provide a brief summary and highlights.

The news reports on this document say that the Basel Committee is proposing that exposure of one bank to another should be limited to 5% of capital. That is not exactly correct. For G-SIBs, the document said that “The Committee…proposes that the appropriate large exposure limit applied to a G-SIB’s exposure to another G-SIB should be between 10% and 15% of the eligible capital base (CET1 or Tier 1). A limit that is tighter than the general limit would reduce the risk of contagion occurring between the banks whose failure has the greatest global systemic impact…”

For non G-SIBs: “…The Committee therefore proposes that the large exposure limit should be 25% of Common Equity Tier 1 (CET1) or Tier 1 capital (see Part III-A). This represents a tightening of the recommended large exposure limit due to the tighter definition of capital employed…”

The 5% number was about a reporting threshold, not a limit.

“…The purpose of monitoring large exposures is to raise early warning flags that may then warrant further investigation by the supervisor. For these flags to be effective, monitoring limits need to be well below the large exposure limit…” and

“…Taking account of data provided by a number of Committee member jurisdictions and the considerations highlighted above, the Committee proposes that the threshold defining a large exposure should be set at 5% of a bank’s eligible capital base…”

The Basel Committee also sees a need to separately address large exposures, especially between SIFIs. “That framework needs to be supplemented with a simple large exposures framework that protects banks from traumatic losses caused by the sudden default of a certain counterparty or group of connected counterparties.” Not to forget shadow banking activity, the BCBS also proposes to include exposure to bank-like activities.

“…The Committee has sought to do this through its proposals on large exposures to funds, securitisation structures and collective investment undertakings (CIU). These proposals include a requirement for banks to apply the look through approach when feasible and to assess possible additional risks that do not relate to the structure’s underlying assets, but rather to the structure’s specific features and to any third parties linked to the structure. Once these risks are identified, a new exposure must be recognised, where appropriate, for large exposure purposes….”

The BIS focuses on establishing a common definition of exposure and capital. The report said that “A stocktaking of Committee member countries’ regulation of large exposures, while showing considerable homogeneity in general approach (consistent with Core Principle 19), revealed material differences in important aspects such as: scope of application; the value of large exposure limits; the definition of capital on which limits were based; methods for calculating exposure values; treatment of credit risk mitigation techniques; and more lenient treatments for certain types of exposures.”

We were confused about a couple of things though. For example, the BCBS wants exposure to connected counterparties to be combined. But then the definition was vague enough to make the net very large:

“Two or more natural or legal persons shall be deemed a group of connected counterparties if at least one of the following criteria is satisfied:

(a) Control relationship: one of them directly or indirectly, has control over the other(s).
(b) Economic interdependence: if one of them were to experience financial problems, in particular funding or repayment difficulties, the other or all of the others would, as a result, also be likely to encounter funding or repayment difficulties. “

The BIS wants to make their rules as objective as possible. Models are too variable and subject to interpretation. Uniform rules are favored in a one-size fits all methodology. The BCBS wants to ignore recovery value – presumably because it is also subjective.

“…the Committee’s view is that credit quality and the amount expected to be recovered in the bankruptcy process should not be considered in a large exposures standard and, hence, not reflected in measures of exposure values. This is because the proposed standard is meant to serve as a simple backstop measure to limit the maximum possible loss that a bank could incur if a single counterparty or group of connected counterparties were to fail…”

The efforts to establish uniform definitions of exposure and capital are certainly impressive and worthwhile. But it feels like the BCBS might be ignoring the inherent and important complexity in the process. The comments are sure to argue for this exemption or that. Will the BCBS stick to its guns? How will these rules inter-play with Dodd-Frank 165, the single counterparty credit limits? Managing the data and technology, especially for large complex financial institutions, will be extraordinarily complex. There is still some work to go to make this document’s proposals into something that can be implemented in practice.

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