The main objectives of the proposed requirements – which update the Basel Committee's 1991 guidelines on large exposures – are to:
- tighten the reporting and "hard" limits on large exposures;
- define more precisely how exposures should be measured, so the requirements can be applied more consistently across countries; and
- introduce tougher limits on the large exposures of systemically important banks.
The proposals echo the principles on data aggregation and reporting published by the Basel Committee in January this year. The Consultation Paper states that the main purpose of the proposals is to ensure greater consistency in the way banks and supervisors measure, aggregate and control exposures to single counterparties.
Implications for firms…
The proposals will add to firms' costs and potentially limit their business activities in five main areas:
- Firms will need to calculate their large exposures on a more conservative basis, which may differ significantly in some respects from current supervisory requirements. This could have major implications for internal data capture and reporting systems – at the same time as firms face operational challenges around the reporting of derivatives and prospective changes to the capital requirements on their trading books.
- Firms will need to report all large exposures above 5% of their common equity tier 1 (CET1) capital base. This is likely to require considerably more regulatory reporting than the current threshold of 10% (of total capital base) applied in most jurisdictions.
- Firms will also need to (i) report large exposures on both a gross basis and net of credit mitigation techniques; and (ii) report large exposures to counterparties to which the "hard" large exposure limit does not apply (eg. sovereigns, central banks and public sector entities).
- The "hard" pillar 1 limit on large exposures (of 25% of capital) will be tightened by a combination of more conservative measurement requirements and a narrowing of the capital base to CET1 capital.
- The large exposures of a globally systemically important bank to another globally systemically important bank will be limited to between 10 and 15% of CET1 capital. It is not yet clear whether central clearing counterparties will be treated as being equivalent to globally systemically important banks for these purposes.
- The tougher reporting and hard limit requirements are likely to be applied not only at a group level but also by some regulators at a solo level for local subsidiaries in host countries, adding further "localisation" pressures on international banking groups.
In the detail…
The Basel Committee proposes that banks should report to their supervisor all their large exposures in excess of 5% of their CET1 capital base, or – if the number of large exposures is fewer than 20 – their largest 20 exposures, irrespective of their size. Large exposures should also be reported both before and after applying credit risk mitigation techniques. Large exposures to counterparties to which the "hard" large exposure limit does not apply (eg. sovereigns, central banks and public sector entities) should also be reported.
The Basel Committee proposes a tightening of its 1991 Guidelines by applying the 25% limit against CET1 capital rather than, as currently, against total capital. On average, this may represent a reduction of around one-third in eligible capital, although this will be offset to some extent by the capital raising undertaken by many banks during the financial crisis.
Systemically important banks (SIBs)
The Basel Committee proposes that the appropriate large exposure limit on a global SIB's exposure to another G-SIB should be between 10% and 15% of CET1 capital base. This tighter limit is proposed to reduce the risk of contagion occurring between banks whose failure would have the greatest global systemic impact.
In addition, national authorities are encouraged to apply these tighter limits to exposures between domestic SIBs, and to the exposures of smaller banks to G-SIBs and D-SIBs.
It is also noted in the Consultation Paper that the same should apply to exposures to non-bank G-SIFIs, and such a limit might be considered by the Basel Committee in the future.
The Consultation Paper sets out a detailed and conservative approach to the measurement of large exposures. This will also represent a tightening of the 25% limit, by increasing the measured size of some exposures.
The starting point is for banks to capture and measure:
- On-balance sheet non-derivative banking book assets, where the exposure measure is typically determined by accounting standards. Although the Consultation Paper includes a question on the use of internal models to calculate large exposures, the preferred approach of the Basel Committee is clearly to use a simpler, non-model based, method that does not reflect credit quality or the amount expected to be recovered if the counterparty defaults (except through eligible credit mitigation techniques);
- Traditional off-balance sheet banking book commitments, where the exposure measure is the product of the notional amount of the commitment and the credit conversion factor (CCF) applied;
- Trading book positions (excluding options), where the exposure measure is based on the mark-to-market approach of the risk-based capital requirements;
- Options in the trading book, where the exposure measure is based on a mark-to-market approach with a jump-to-default assumption; and
- Counterparty credit risk from derivatives, securities financing transactions, and long settlement transactions across both banking and trading books, where the proposed approach is for banks to use the current exposure method, rather than the standardised method or the internal models method.
Credit risk mitigation
For credit risk mitigation, the proposed approach is to apply the same minimum requirements and eligibility criteria for the recognition of unfunded credit protection and financial collateral as under the standardised approach for risk-based capital requirement purposes. This is proposed as the most prudent and the simplest and least burdensome option.
Within this approach to credit risk mitigation, the original exposure can be reduced by the post-haircut amount of collateral (where the collateral is of the type recognised for risk-based capital requirement purposes under the standardised approach). For the purpose of calculating large exposures, it is proposed that the haircuts used to reduce the collateral amount would be the supervisory haircuts used under the standardised approach, so internally modelled haircuts could not be used. In addition, banks would have to treat the amount by which the underlying exposure has been reduced due to the existence of collateral as an exposure to the issuer of the collateral in its own right (and add it to any other exposures the bank may have to that issuer for the purpose of large exposures).
The same reporting and "hard" limits would apply to interbank exposures. However, the Basel Committee recognises that banks may face potential constraints here given the different payment and settlement systems they operate in, or in relation to monetary policy implementation. The Basel Committee is therefore seeking evidence to determine whether some exemptions might be needed for (i) intraday interbank exposures and (ii) some overnight interbank exposures.
Investments in securitisations and funds
The Consultation Paper proposes that banks apply a look-through approach (LTA) to identify the underlying assets when they invest in securitisations or investment funds. However:
- This need not be applied where the largest underlying exposure does not exceed 1% of the total value of the securitisation or fund;
- Where a bank cannot look-through to all the underlying assets, it is proposed that banks set up a separate "unknown client" counterparty and aggregate all unknown exposures to this "unknown client". The large exposure limit would then apply to this "unknown client" in the same way as to any known counterparty.
The Consultation Paper asks for comments on two options for exposures to central counterparties:
- Option 1 - apply limits to banks' exposures to qualifying central counterparties, albeit possibly with higher than 25% limits to take into account the fact that banks are obliged to clear specific trades through CCPs and that CCPs can contribute to reducing systemic risk.
- Option 2 - no "hard" pillar 1 hard limit would apply to a bank's exposures to qualifying CCPs, but banks would still be required to report all such large exposures to their supervisors, who in turn would monitor potential concentration risks and take appropriate supervisory actions where needed.
The Basel Committee recognises that banks and supervisors would require time to transition to the proposed new large exposures requirements, and therefore proposes that all aspects of its proposals should be implemented in full by 1 January 2019.