Basel Committee on Banking Supervision Standards

This standard has been integrated into the consolidated Basel Framework:

Basel Committee on Banking Supervision

Standards

Supervisory framework for measuring and controlling large exposures

April 2014

This publication is available on the BIS website ().

? Bank for International Settlements 2014. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated.

ISBN 978-92-9197-987-5 (print) ISBN 978-92-9197-988-2 (online)

Contents

Abbreviations .......................................................................................................................................................................................ii

Supervisory framework for measuring and controlling large exposures .................................................................... 1

I. Introduction................................................................................................................................................................................ 1 A. Rationale and objectives of a large exposures framework............................................................................. 1 B. Other types of concentration risk............................................................................................................................. 3

II. Overall design of a prudential framework for large exposures ............................................................................. 3 A. Scope and level of application .................................................................................................................................. 3 B. Scope of counterparties and exemptions ............................................................................................................. 3 C. Definition of a large exposure and regulatory reporting................................................................................ 4 D. Minimum requirement ? the large exposure limit............................................................................................. 4 E. Definition of connected counterparties................................................................................................................. 4

III. Values of exposures ................................................................................................................................................................ 6 A. General measurement principles .............................................................................................................................. 6 B. Definition of exposure value ...................................................................................................................................... 6 C. Eligible credit risk mitigation (CRM) techniques ................................................................................................ 7 D. Recognition of CRM techniques in reduction of original exposure ........................................................... 8 E. Recognition of exposures to CRM providers ....................................................................................................... 8 F. Calculation of exposure value for trading book positions ............................................................................. 9 G. Offsetting long and short positions in the trading book..............................................................................10

IV. Treatment of specific exposure types ............................................................................................................................11 A. Sovereign exposures and entities connected with sovereigns...................................................................11 B. Interbank exposures ....................................................................................................................................................11 C. Covered bonds...............................................................................................................................................................12 D. Collective investment undertakings, securitisation vehicles and other structures .............................13 E. Exposures to central counterparties......................................................................................................................15

V. Large exposures rules for global systemically important banks .........................................................................16

VI. Implementation date and transitional arrangements..............................................................................................17

Supervisory framework for measuring and controlling large exposures

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Abbreviations

ABS CDO CDS CCF CIU CCP CRM D-SIB ECAI G-SIB G-SIFI IRB LTA OTC PD Q-CCP SA-CCR SIFI SFT

Asset-backed securities Collateralised debt obligation Credit default swap Credit conversion factor Collective investment undertaking Central counterparty Credit risk mitigation Domestic systemically important bank External credit assessment institution Global systemically important bank Global systemically important financial institution Internal ratings-based Look-through approach Over-the-counter Probability of default Qualifying central counterparty Standardised approach for counterparty credit risk Systemically important financial institution Securities financing transaction

ii

Supervisory framework for measuring and controlling large exposures

Supervisory framework for measuring and controlling large exposures

I. Introduction

A. Rationale and objectives of a large exposures framework

1.

One of the key lessons from the financial crisis was that banks did not always consistently

measure, aggregate and control exposures to single counterparties or to groups of connected

counterparties across their books and operations. Throughout history there have been instances of

banks failing due to concentrated exposures to individual counterparties (eg Johnson Matthey Bankers

in the United Kingdom in 1984, the Korean banking crisis in the late 1990s). Large exposures regulation

has been developed as a tool for limiting the maximum loss a bank could face in the event of a sudden

counterparty failure to a level that does not endanger the bank's solvency.

2.

The need for banks to measure and limit the size of large exposures in relation to their capital

has long been recognised by the Basel Committee on Banking Supervision (the Committee). In particular,

in 1991, the Committee reviewed supervisory practices and issued supervisory guidance on large exposures.1 In a similar vein, the Core Principles for Effective Banking Supervision (Core Principle 19)

require that local laws and bank regulations set prudent limits on large exposures to a single borrower or a closely related group of borrowers.2 But neither the 1991 guidance nor the Core Principles set out how

banks should measure and aggregate their exposures to a single counterparty, nor do they explain

which factors should be taken into account when considering whether separate legal entities form a

group of connected counterparties. This has resulted in a considerable variation of practice across the

globe. A stocktake of Committee member countries' regulations of large exposures showed considerable

homogeneity in general (consistent with Core Principle 19) but 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 whether certain types of exposures were subject to more lenient treatments.

3.

A large exposures framework complements the Committee's risk-based capital standard

because the latter is not designed specifically to protect banks from large losses resulting from the

sudden default of a single counterparty. In particular, the minimum capital requirements (Pillar 1) of the

Basel risk-based capital framework implicitly assume that a bank holds infinitely granular portfolios, ie no

form of concentration risk is considered in calculating capital requirements. Contrary to this assumption,

idiosyncratic risk due to large exposures to individual counterparties may be present in banks' portfolios.

Although a supervisory review process (Pillar 2) concentration risk adjustment could be made to mitigate

1 The first Basel Committee guidance on this topic, Measuring and controlling large credit exposures, was published in January 1991 in an attempt to increase convergence in the supervision of large exposures while recognising the scope for variation according to local conditions. This best practice for bank supervisors in the monitoring and controlling of large credit exposures was developed in the context of the standards in Basel I. It included numerical limits as a percentage of Basel I capital, the definition of which has been subsequently revised in later vintages of the Basel capital framework and more recently and substantively in Basel III.

2 Principle 19 states "The supervisor determines that banks have adequate policies and processes to identify, measure, evaluate, monitor, report and control or mitigate concentrations of risk on a timely basis. Supervisors set prudential limits to restrict bank exposures to single counterparties or groups of connected counterparties." (The Core Principles for Effective Banking Supervision, published by the Committee in September 2012, are accessible at publ/bcbs230.pdf).

Supervisory framework for measuring and controlling large exposures

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this risk,3 these adjustments are neither harmonised across jurisdictions, nor designed to protect a bank against very large losses from a single counterparty default. For this reason, the Committee has concluded that the existing risk-based capital framework is not sufficient to fully mitigate the microprudential risk from exposures that are large compared to a bank's capital resources. That framework needs to be supplemented with a simple large exposures framework that protects banks from traumatic losses caused by the sudden default of an individual counterparty or group of connected counterparties. To serve as a backstop to risk-based capital requirements, the large exposures framework should be designed so that the maximum possible loss a bank could incur if a single counterparty or group of connected counterparties were to suddenly fail would not endanger the bank's survival as a going concern.

4.

The treatment of large exposures could also contribute to the stability of the financial system in

a number of other ways, a consideration that the Committee believes should be reflected in the design

of the large exposures framework.

5.

A separate key lesson from the crisis is that material losses in one systemically important

financial institution (SIFI) can trigger concerns about the solvency of other SIFIs, with potentially

catastrophic consequences for global financial stability. There are at least two important channels for this

contagion. First, investors may be concerned that other SIFIs might have exposures similar to those of

the failing institution. For example, in 2008, in response to the announcement of material losses on

exposures to some asset-backed securities (ABS) and collateralised debt obligations (CDOs) incurred by

a number of large banks, investors withdrew funds from other banks believed to have similar exposures,

threatening their liquidity and solvency. Second, and more directly, investors may be concerned that

other SIFIs have direct large exposures to the failing SIFI, in the form of either loans or credit guarantees.

For example, one of the key concerns regarding AIG in September 2008 was that a number of SIFIs were

believed to have bought large amounts of credit protection from AIG. The Committee is of the view that

the large exposures framework is a useful tool to mitigate the risk of contagion between global

systemically important banks, thus supporting global financial stability. Consequently, a relatively tighter

limit on exposures between G-SIBs is included in the framework.

6.

This framework is also seen as a useful tool to contribute to strengthening the oversight and

regulation of the shadow banking system in relation to large exposures.4 In particular, this is the case for

the proposals for the treatment of exposures to funds, securitisation structures and collective investment

undertakings (CIU). The framework thus includes a requirement for banks to apply a look-through

approach (LTA) when appropriate, 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,

which is subject to the large exposure limit.

7.

As part of the Committee's broader efforts to avoid adding unnecessary complexity in the Basel

standards, the framework follows, where practicable, existing standards in the Basel framework and

departs from them only if this is necessary for the purpose of achieving the objectives of the large

exposures framework. Accordingly, this document includes a number of references to the Basel riskbased capital framework.5

3 The market risk framework also explicitly requires that trading book models for specific risk capture concentration risk.

4 See FSB, Shadow Banking: Strengthening Oversight and Regulation, Recommendations of the FSB, October 2011, and in particular Recommendation 2, p 17.

5 Unless stated otherwise, the corresponding document is Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version (June 2006), which can be accessed at

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Supervisory framework for measuring and controlling large exposures

B.

Other types of concentration risk

8.

The Committee recognises that the risk from large exposures to single counterparties or groups

of connected counterparties is not the only type of concentration risk that could undermine a bank's

resilience. Other types include both sectoral and geographical concentrations of asset exposures;

reliance on concentrated funding sources; and also a significant net short position in securities, because

the bank may incur severe losses if the price of these securities increases. The Committee has decided to

focus this framework on losses incurred due to default of a single counterparty or a group of connected

counterparties and not to take into account any other type of concentration risk.

9.

Similarly, intragroup exposures have not been included in the scope of this framework,

although they could be considered as another source of concentration risk that might potentially

endanger banks' survival.

II. Overall design of a prudential framework for large exposures

A. Scope and level of application

10.

The large exposures framework is constructed to serve as a backstop and complement to the

risk-based capital standards. As a consequence, it must apply at the same level as the risk-based capital

requirements are required to be applied following paragraphs 21 and 22 of the Basel II text, ie at every

tier within a banking group.

11.

The large exposures framework is applicable to all internationally active banks. As with all other

standards issued by the Committee, member jurisdictions have the option to set more stringent

standards. They also have the option to extend the application to a wider range of banks, with the

possibility ? if they deem it necessary ? to develop a different approach for banks that usually fall outside the scope of the Basel framework.6

12.

The application of the large exposures framework at the consolidated level implies that a bank

must consider all exposures to third parties across the relevant regulatory consolidation group and

compare the aggregate of those exposures with the group's eligible capital base.

B.

Scope of counterparties and exemptions

13.

A bank must consider exposures to any counterparty. The only counterparties that are

exempted from the framework are sovereigns as defined in paragraph 61. Section IV sets out the types

of counterparties that are exempted from the large exposure limit or for which another specific

treatment is necessary.

publ/bcbs128.htm, as subsequently modified by Revisions to the Basel II market risk framework and Enhancements to the Basel II framework both issued in July 2009 (accessible at and at ) and by Basel III: A global regulatory framework for more resilient banks and banking systems - revised version June 2011, accessible at ).

6 For instance, the Committee notes that for these banks that fall outside the scope of application of the Basel framework, there may be a case for recognising physical collateral, which is not recognised in the large exposures framework set out in this document.

Supervisory framework for measuring and controlling large exposures

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C. Definition of a large exposure and regulatory reporting

14.

The sum of all exposure values of a bank to a counterparty or to a group of connected

counterparties, as defined in Section II part E below, must be defined as a large exposure if it is equal to

or above 10% of the bank's eligible capital base. The exposure values must be measured as specified in

Sections III and IV.

15.

Banks must report to the supervisor the exposure values before and after application of the

credit risk mitigation techniques. Banks must report to the supervisor:

(i)

all exposures with values measured as specified in Sections III and IV equal to or above 10% of

the bank's eligible capital (ie meeting the definition of a large exposure);

(ii)

all other exposures with values measured as specified in Sections III and IV without the effect of

credit risk mitigation being taken into account equal to or above 10% of the bank's eligible

capital;

(iii)

all the exempted exposures with values equal to or above 10% of the bank's eligible capital;

(iv)

their largest 20 exposures to counterparties measured as specified in Sections III and IV and

included in the scope of application, irrespective of the values of these exposures relative to the

bank's eligible capital base.

D. Minimum requirement ? the large exposure limit

16.

The sum of all the exposure values of a bank to a single counterparty or to a group of

connected counterparties must not be higher than 25% of the bank's available eligible capital base at all

times. However, as explained in Section V, this figure is set at 15% for a G-SIB's exposures to another

G-SIB.

17.

The exposures must be measured as specified in Sections III and IV. The eligible capital base is

the effective amount of Tier 1 capital fulfilling the criteria defined in Part 1 of the Basel III framework.7

18.

Breaches of the limit, which must remain the exception, must be communicated immediately to

the supervisor and must be rapidly rectified.

E.

Definition of connected counterparties

19.

In some cases, a bank may have exposures to a group of counterparties with specific

relationships or dependencies such that, were one of the counterparties to fail, all of the counterparties

would very likely fail. A group of this sort, referred to in this framework as a group of connected

counterparties, must be treated as a single counterparty. In this case, the sum of the bank's exposures to

all the individual entities included within a group of connected counterparties is subject to the large

exposure limit and to the regulatory reporting requirements as specified above.

20.

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 the counterparties, directly or indirectly, has control over the

other(s).

7 Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010 (rev June 2011) is accessible at .

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Supervisory framework for measuring and controlling large exposures

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