Challenges in supervising banks' large exposures

FinancialStabilityInstitute FSIInsights onpolicyimplementation No52 Challengesinsupervisingbanks’largeexposures ByVasilyPozdyshev,Jean-PhilippeSvoronosandRize-MarivanZyl November2023 JELclassification:G21,G28 Keywords:finance,banklending,commercialbanks,bankregulation,standard,supervision FSIInsightsarewrittenbymembersoftheFinancialStabilityInstitute(FSI)oftheBankforInternationalSettlements(BIS),oftenincollaborationwithstafffromsupervisoryagenciesandcentralbanks.Thepapersaimtocontributetointernationaldiscussionsonarangeofcontemporaryregulatoryandsupervisorypolicyissuesandimplementationchallengesfacedbyfinancialsectorauthorities.TheviewsexpressedinthemaresolelythoseoftheauthorsanddonotnecessarilyreflectthoseoftheBISortheBasel-basedcommittees. AuthorisedbytheChairoftheFSI,FernandoRestoy. ThispublicationisavailableontheBISwebsite(www.bis.org).TocontacttheBISMediaandPublicRelationsteam,pleaseemailmedia@bis.org.Youcansignupforemailalertsatwww.bis.org/emailalerts.htm. ©BankforInternationalSettlements2023.Allrightsreserved.Briefexcerptsmaybereproducedortranslatedprovidedthesourceisstated. ISSN2522-249X(online) ISBN978-92-9259-699-6(online) Contents Executivesummary1 Section1–Introduction3 Section2–MainfeaturesandchallengesassociatedwiththeLEXstandard5 Section3–Thechallengesofidentifyingconnectedcounterparties7 Regulatorydefinitionandassessmentcriteriaforconnectedcounterparties7 Section4–Approachesforspecifictypesofexposures13 Approachtointragroupexposures13 Related-partylending(RPL)–a“greyarea”?15 Interbankexposures17 Section5–Creditriskmitigation(CRM)techniquesandchallenges24 EligibilityofCRMtechniques25 ChallengesrelatedtoassessingtheeffectivenessofCRMtechniques25 Section6–Reportingandsupervisorymonitoring26 Reportingrequirementsandpractices26 Section7–Breaches,supervisorymeasuresandreturntocompliance27 Identifyingbreaches28 Analysingbreaches29 Correctivemeasures30 Timeframestoreturntocompliance:theoryandpractice32 Section8–Conclusions34 References35 Challengesinsupervisingbanks’largeexposures1 Executivesummary Recentfailurestomanagecounterpartyriskserveasareminderoftheneedtocontrolandlimitriskconcentrations.TheoriginofthefailureofArchegosCapitalManagement,afamilyofficeofaformerhedgefundmanager,canbefoundintheconcentratedriskexposuresthatitbuiltupandmismanaged.Archegosbuiltlargeandhighlyleveragedequitypositionsthroughtotalreturnequityswapswithseveralbankswhowereunawareofitsoverallpositionsandhadalso,inthecaseofCreditSuisseinparticular,insufficientlycollateralisedtheirexposuretothefamilyoffice.Whenthevalueofthesepositionscontractedsharply,Archegosdefaultedonitsmargincalls,withseveraloftheexposedbankssufferinglargelosses. Regulatorshavelongrecognisedtheneedtopreventbanksfrombecomingoverexposedtoasinglecounterparty.Thisisbecausesuchaconcentrationexposesabanktodisproportionatelylargelossesshouldthiscounterpartyfail.Accordingly,theneedtolimitthesizeoftheseexposuresisafundamentalprincipleofprudentialregulationandensuringthatbanksabidebysuchregulationisacorecomponentofbankingsupervision.Thisprincipleformsthebasisofthelargeexposures(LEX)standardissuedbytheBaselCommitteeonBankingSupervision(BCBS),whichcomplementstherisk-basedcapitalstandards. Multiplesupervisorychallengesmakethisstandarddifficulttoenforceandpartlyexplainthewiderangesofjurisdictionalpractices.Thesechallenges,difficultiesandrangesofpracticesrelatetothesupervisoryauthority’sabilitytoconductcasebycaseassessmentsanduseitssupervisoryjudgmentassuchassessmentsareneededthroughoutthestandard.Challengesincludethoserelatedtotheabilitytodeterminewhetherexposuresareconnectedornot;whetherexposuresfallwithinthescopeofthestandardorconstitutespecialcasesthatwarrantspecifictreatmentsorexemptions;whetherandtowhatextentexposuresaremitigated;andhowtotreatbreaches.Thesechallenges,andhowsupervisoryauthoritieshavesoughttoovercomethem,arediscussedinthispaper. Thefirstsetofchallengesistoidentifyandassessgroupsofconnectedcounterparties.Connectedcounterpartiesarethosethathaverelationshipssuchthat,shouldoneofthecounterpartiesfail,theotherswouldverylikelyfail.Establishinginterconnectednessgeneratesanassumptionthatexposurestothesecounterpartiesconstituteasinglerisk.Todeterminewhethercounterpartiesareconnected,banksmustusecontrolrelationshipcriteriaandeconomicdependencecriteria.Inpractice,establishinginterconnectednessdoesnotalwaysleadtoaggregatingtheexposures.Thisisbecausethecriteriamaynotbesufficienttoestablishaconnectionbetweenthecounterpartiesorbecausetheconnectionisnotsufficientlystrongtoconsiderthattheexposuresconstituteasinglerisk.Whenthistakesplace,thesupervisordetermineswhethertheexposuresconstituteasingleriskornotbasedonthebank’sanalysis. Anothersetofchallengesisthelackofcommoncriteriaapplicabletoallexposures.TherearevariousapproachesthatarespecifictocertainexposuresundertheLEXstandard,andspecificapproachesmayneedtobedesignedtoaddressjurisdictionalchallenges.Examplesofspecifictreatmentsincludethevaluationoftradingbookpositions.Exemptionsincludeentitiesconnectedwithsoverei