Review of issues relating to Highly Leveraged Institutions

March 2001

Preface

In January 1999, the Basel Committee on Banking Supervision issued a report on Banks' Interactions with Highly Leveraged Institutions (HLIs).1 2 This evaluated the quality of banks' risk management practices toward HLIs and the related supervisory and regulatory issues. The Basel Committee also published guidance on Sound Practices relating to banks' interactions with HLIs.3 The Technical Committee of IOSCO has also produced a report on securities firms' interactions with HLIs in November 1999.4 The nature of these interactions, the risks and the recommendations for sound practices in mitigating these were very similar to those identified for banks. During 1999, the Basel Committee, through its Working Group on Highly Leveraged Institutions, focused on monitoring the implementation of the Sound Practices paper and published a review of compliance with its Sound Practices in early 20005. That paper outlined a series of issues relating to HLIs which required further attention from banks, supervisors, and international groups. It also proposed continued collaboration between bank and security firm regulators and ongoing dialogue with the financial industry, particularly in challenging technical areas such as measurement of potential future credit exposure and stress testing. The paper set out a proposed framework for such collaboration and dialogue.

As an outcome of that proposal, sub groups of the Basel Committee Risk Management Group and the IOSCO Task Force on HLIs met to establish common areas of interest in risk management practices of banks and securities firms with respect to their dealings with HLIs. It was proposed that the group should meet 2 to 3 times over a period of 12 to 18 months. Thereafter it would automatically be disbanded unless compelling reasons were found to continue its work.

Accordingly, a joint Basel/IOSCO Highly Leveraged Institutions' Working Group (HLIWG) was established in the spring of 2000, and met on two occasions, in May and November 2000. On both occasions it heard presentations from firms with exposures to HLIs. The HLIWG also undertook a survey during the summer of 2000. This survey, conducted through national supervisors, explored a number of topics, including: the nature of firms' involvement with HLIs, management reporting and governance structure, information gathering, due diligence and credit analysis, exposure measurement, credit terms and limit setting, and collateral, early termination and documentation issues.

1 Banks' Interactions with Highly Leveraged Institutions, Basel Committee on Banking Supervision, January 1999

2 In its previous work on HLIs the Basel Committee outlined the following characteristics of such institutions: (i) they are subject to very little or no direct regulatory oversight. In the case of HLIs, this limited regulatory oversight results from such entities being structured as limited partnerships, investors being either institutions or sophisticated high net worth individuals and the securities issued taking the form of private placements. Moreover, a significant proportion of HLIs operate through offshore financial centres. (ii) HLIs are generally subject to very limited disclosure requirements, compared with regulated financial institutions and/or publicly traded companies, and are not subject to rating by credit-rating agencies. (iii) such institutions often take on significant leverage, where leverage is the ratio between risk, expressed in some common denominator, and capital. IOSCO, for the purposes of its report used a similar classification. It was recognised at the time of those reports that 'highly leveraged institution' was not an ideal characterisation of all of the unregulated counterparties with which they were concerned. This remains the case but the term HLI has been retained in this report for continuity.

3 Sound Practices for Banks' Interactions with Highly Leveraged Institutions, Basel Committee on Banking Supervision, January 1999

4 Hedge Funds and Other Highly Leveraged Institutions, Report by the Technical Committee of IOSCO, November 1999

5 Banks' Interactions with Highly Leveraged Institutions: Implementation of the Basel Committee's Sound Practices Paper, Basel Committee on Banking Supervision, January 2000