No. 2196

Thursday, January 28, 1999

Banks' Interactions With Highly Leveraged Institutions

In response to recent financial market developments, and as part of its ongoing efforts to encourage prudent risk management practices in banking institutions, the Basle Committee on Banking Supervision today issued a report analyzing banks’ interactions with highly leveraged institutions (HLIs), together with guidance on sound practices in such dealings.

Mr. William J. McDonough, Chairman of the Basle Committee and President of the Federal Reserve Bank of New York, stated: "Recent events, most notably the near-collapse of Long-Term Capital Management, have underscored the need for a full understanding and prudent management of the particular risks generated from banks’ interactions with HLIs – risks both to the direct creditors and, under certain market conditions, to the financial system as a whole." Mr. McDonough added that the Basle Committee hopes this report will encourage banks and supervisors to give careful consideration to these potential risks, assess banks’ risk management practices with respect to HLIs and evaluate potential policy responses to address these risks.

The report was prepared by a Working Group of the Basle Committee, chaired by Mr. Jan Brockmeijer of the Netherlands Bank. Mr. Brockmeijer noted that the objective in issuing the sound practice guidance was to "encourage the development of prudent approaches to the assessment, measurement and management of exposures to HLIs." The recommended sound practices include:

• establishing clear policies and procedures for interactions with HLIs as part of the overall credit risk management environment;

• employing sound information gathering, due diligence and credit analysis practices which address the specific risks associated with HLIs;

• encouraging the development of more accurate measures of exposures resulting from trading and derivatives transactions;

• setting meaningful overall credit limits for HLIs;

• linking credit enhancement tools, including collateral and early termination provisions, to the specific characteristics of HLIs; and

• closely monitoring credit exposures vis-à-vis HLIs, taking into account their trading activities, risk concentration, leverage and risk management processes.

While the report highlights several deficiencies in some banks’ risk management practices with respect to certain HLIs, it notes that most institutions with exposures to HLIs appear to be tightening their standards following the events of last autumn. Hence, according to Mr. Brockmeijer, a key reason for issuing the sound practice guidance was to ensure that these improvements are "locked in" over time.

The Committee also considered the desirability and feasibility of a number of other regulatory and supervisory measures, including efforts to enhance transparency, as well as direct regulation of HLIs. The report notes that assessment of the costs, benefits, and effectiveness of direct regulation would require a comprehensive review of the potential impact on financial markets and market participants. Such measures would also extend beyond the sole purview of bank supervisors, and would require broader co-ordination with other parties. The Committee also emphasized that many of the systemic risks associated with the activities of HLIs can be addressed through better risk management at the counterparty level. Prudent internal risk management can have the additional benefit of limiting or reducing the leverage of HLIs, and limiting the riskiness of HLI portfolios. As such, it may also reduce the potential for systemic disruptions resulting from a rapid deleveraging or liquidation of positions, and may contribute to greater stability in the financial system as a whole.

Notes for editors

The Basle Committee on Banking Supervision

The Basle Committee on Banking Supervision is a Committee of banking supervisory authorities established by the central bank Governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks of Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. Its current chairman is Mr. William J. McDonough, President of the Federal Reserve Bank of New York. The Committee usually meets at the Bank for International Settlements (BIS) in Basle, where its permanent Secretariat is located.

The Working Group on Highly Leveraged Institutions

The Working Group on Highly Leveraged Institutions was set up by the Basle Committee in October 1998, with a mission to analyze the nature of the risks posed by highly leveraged institutions, to assess banks’ risk management practices with respect to HLIs, and to evaluate potential policy responses to address these risks. The Working Group consists of supervisory experts from several member institutions of the Basle Committee. It is chaired by Mr. Jan Brockmeijer, Deputy Director, the Netherlands Bank.

What is an HLI?

The Basle Committee acknowledges that it is very difficult to provide a precise definition of an HLI; for purposes of the analysis in this report, the focus was on large financial institutions that are subject to little or no direct regulatory oversight and limited disclosure requirements, and which take on significant leverage. The Committee recognizes that not all so-called hedge funds have these characteristics, while many mainstream financial institutions, such as banks and security houses, exhibit some of them. As such, the recommendations of the report refer to banks’ dealings with institutions that pose the particular counterparty risks arising from such characteristics, however they may be classified.

Monitoring aggregate counterparty exposure

Monitoring aggregate counterparty exposures should be based on meaningful "loan equivalent" exposure measures. The measurement of exposures resulting from OTC derivatives contracts, which represent an important part of aggregate counterparty exposures to HLIs, requires information on current exposures, as well as consistent methodologies for measuring potential future exposure. The Committee encourages the industry to continue its efforts to improve and standardize methodologies for measuring potential future exposure.

Where can I obtain the full report?

The two texts, "Banks’ Interactions with Highly Leveraged Institutions," and "Sound Practices for Banks’ Interactions with Highly Leveraged Institutions," can be obtained from the BIS website as of 16:30 (BST) on 28th January. The report is also available from the Basle Committee’s Secretariat at the BIS and from member bank supervisory authorities and central banks.