The Basel Committee has released a Consultative Document which proposes the introduction of global controls on banks' "large exposures" for the first time. Currently, individual banks typically apply national large exposures rules, which are often derived from the Basel Committee's own Core Principles for Effective Banking Supervision (updated in 2012) and its 1991 guidance on Measuring and Controlling Large Credit Exposures. Within Europe, the Capital Requirements Directive (CRD) sets large exposures rules for European banks which are often further supplemented at national level - see by way of example the UK regulator's Guidance on the treatment of exposures to structured finance vehicles which was summarised in Edition 1 of this SCM Briefing. However, the imposition of large exposure limits at holding company level is new, and the Basel Committee's proposals reflect its post-Global Financial Crisis desire to limit single-counterparty as well as multiple connected-counterparty exposures. The Basel Committee's view is that its revised risk-based capital framework under Basel III should be supplemented with a simple large exposures framework that acts as a backstop to protect banks from traumatic losses caused by the sudden default of a certain counterparty or group of connected counterparties (or indeed, by another bank with which it is systemically connected). In addition, the Basel Committee makes further proposals to address the risks posed by shadow banks in relation to large exposures, as highlighted by the Financial Stability Board in its earlier Recommendations for strengthening the oversight and regulation of the shadow banking industry). The Basel Committee's proposals may be summarised as follows:
- A large exposure would be defined as any exposure that amounts to 5% or more of a bank's eligible capital base, with specific comment sought on measuring exposure value using internal models (which the Basel Committee proposes should not be permitted), and for calculating exposure value in both banking and trading books;
- The actual large exposures limit that would be imposed (i.e. the limit of all large exposures combined) should be set at a "hard" limit of 25% of a bank's "eligible capital base", which is defined as Common Equity Tier 1 (as defined in Basel III), as opposed to the existing, less stringent definition of capital base which is a bank's total (regulatory) capital. Thus, without increasing the existing 25% limit, the Basel Committee proposes a tightening of the limit, given that Common Equity Tier 1 now represents a much narrower portion of a bank's total capital;
- For Global Systemically Important Banks (G-SIBs) however, the Basel Committee proposes that the appropriate large exposures limit for a G-SIB's exposure to another G-SIB be set at between 10% and 15% of the relevant G-SIB's eligible capital base. The Basel Committee also proposes applying this tighter limit to Domestic Systemically Important Banks (D-SIBs) and other, non-bank, systemically important institutions (SIFIs);
- The definition of a large exposure would encompass direct exposures to single counterparties or groups of connected counterparties, as well as exposures to credit protection providers. Thus, exposures arising from the purchase of credit protection would be added to the total of any other direct exposures to the same counterparty;
- All large exposures would have to be reported to supervisors, or, if the number of large exposures is less than 20, the bank would have to report its 20 largest exposures irrespective of their size. In addition, large exposures to counterparties to which the large exposures limit does not apply (e.g. sovereigns) would also have to be reported;
- The rules would capture on-balance sheet banking book assets, traditional off-balance sheet banking book commitments (applying a very conservative, flat 100% credit conversion factor), trading book positions, options positions in the trading book, and counterparty credit risk in derivatives, securities financing and long settlement transactions;
- Specific treatment for specific exposure types would allow some to be excluded (exposures to sovereigns, central banks and public-sector entities treated as sovereigns), others specifically included (interbank exposures), further exposures that are subject to comment and discussion (central counterparties) and others that would require a more detailed assessment (such as investments that give rise to exposure to underlying assets, e.g. collective investment undertakings and securitisations - see further below);
- A series of rules for the determination of "connected counterparties", based on control and economic interdependence, along with minimum guidelines for supervisors to use when assessing connections;
- Reflecting the Basel Committee's desire that the large exposures framework encompass "shadow banking" entities, a series of proposals that would require the calculation of the exposure value of banks' investments in OTC derivatives, securities financing transactions, collective investment schemes and to certain securitisation structures. These propose a sequential approach to determining the treatment of investments in these structures (assessing granularity, then applying a complex look-through approach to non-granular pools, applying a de minimis granularity threshold such that a transaction may be considered sufficiently granular if the largest underlying exposure does not exceed 1% of the total transaction value). Further, the look-through approach would require banks to assess possible risks beyond the underlying assets, including those relating to a structure's specific features and to any third parties;
- An approach to the recognition of credit risk mitigation techniques that would reduce the amount of the large exposure in accordance with the level of financial collateral, and proposals to allow the offsetting of long and short positions in the trading book; and
- Two separate proposals for the application of the large exposures rules to central counterparties (either through imposing a hard limit on exposures to qualifying CCPs that may be higher than the general 25% limit, or by not imposing any limit but requiring the reporting of qualifying CCP exposures), on which the Basel Committee seeks detailed input.
Comments on the Basel Committee's proposed approach to large exposures, and responses to the specific questions posed in the Consultative Document, are requested by 28 June 2013. It is envisaged that the revised large exposures framework would apply from 1 January 2019, coinciding with the full implementation of the new regulatory framework for G-SIBs that has been developed by the Basel Committee in conjunction with the Financial Stability Board. Further analysis of the Basel Committee's plans for large exposures, including how they may interact with the separate US rules under the Dodd-Frank legislation, will be provided following the end of the consultative period and publication of the final framework.