Basel Committee on Banking Supervision

The global financial crisis of 2007-09 showed that Banks sometimes have incentives beyond, or in the absence of, contractual obligations or equity ties to ”step in” to support unconsolidated entities to which they are connected. In some cases, banks may prefer to support certain non-bank financial intermediation (NBFI) entities (such as securitisation conduits, structured investment vehicles or money market funds) in financial distress, rather than allow them to fail and face themselves a loss of reputation, even though they have neither ownership interests in such entities nor any contractual obligations to support them. This can result in risks spilling over from the NBFI system to banks. Prominent examples of credit or liquidity support provided by banks were observed during the crisis, including for securitisation conduits, structured investment vehicles and money market funds (MMFs).

Although existing standards, including the Basel Framework, and guidelines generally reduce the likelihood of a bank stepping in to provide financial support, this step-in risk still exists and necessitates a forward-looking structured approach.1

The following terms are used throughout this chapter and have the meaning given below:

1. Accounting consolidation: includes all the entities that are consolidated according to the relevant accounting frameworks and as reflected in the consolidated financial statements of the group. From an accounting standpoint, consolidation is currently based on the notion of control, as defined by the relevant accounting standards.
2. Consolidation: this term usually describes the accounting procedure aggregating the components of financial statements (eg balance sheet items such as assets and liabilities) of different entities line by line, while eliminating any inter-entity balances and transactions in order to produce a group’s single aggregate record, as if it were that of a single legal entity
3. Debt or equity investor: a relationship whereby the bank invests in the entity’s debt or equity instruments. However, for the purposes of this chapter banks should exclude regular business such as a lending relationship to operating entities (eg a wholesale loan to a corporate entity) and investments that arise from market-making (eg equity shares held in the trading book or negligible investment).
4. HQLA: high quality liquid assets as defined in the liquidity coverage ratio standard.
5. LCR: liquidity coverage ratio as defined in the Basel Framework.
6. NSFR: net stable funding ratio as defined in the Basel Framework.
7. Non-Bank Financial Intermediation (NBFI): credit intermediation involving entities and activities (fully or partially) outside the regular banking system, (formerly referred to as shadow banking). This chapter focuses on the situations that give rise to step-in risk, rather than trying to provide a definition of a category of entities that should be considered.
8. Operational risk: the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. If step-in risk is related to reputational risk, it is distinct from operational risk
9. Other contractual and non-contractual involvement: a relationship whereby the bank is exposed to the risks or to equity-like returns from the assets of the entity or related to its performance.
10. Regulatory consolidation: according to the Basel Framework (see SCO Scope and definitions chapter), the scope of regulatory consolidation includes all banking and relevant financial entities meeting regulatory criteria or threshold for triggering consolidation.
11. Reputational risk: the risk arising from negative perception on the part of customers, counterparties, shareholders, investors, debt-holders, market analysts, other relevant parties or regulators that can adversely affect a bank’s ability to maintain existing, or establish new, business relationships and continued access to sources of funding (eg through the interbank or securitisation markets). As such, step-in risk is one possible source of reputational risk. It arises when a bank considers that it is likely to suffer a negative impact from the weakness or failure of an entity and concludes that this impact is best mitigated, ceteris paribus, by stepping in to provide financial support.
12. Sponsor: a relationship whereby the bank manages or advises the entity, places its securities into the market or provides it with liquidity and/or credit enhancements.
13. Step in risk: the risk that a bank decides to provide financial support to an unconsolidated entity that is facing stress, in the absence of, or in excess of, any contractual obligations2 to provide such support. The main reason for step-in risk might be to avoid the reputational risk that a bank might suffer were it not to provide support to an entity facing a stress situation.
14. Unconsolidated entity: an entity not within the scope of regulatory consolidation.

The guidelines in this chapter seek to identify situations where step-in risk exists and needs to be anticipated. They seek to combine simplicity with sensitivity to residual step-in risk (ie step-in risk after consideration of risk mitigants). These guidelines aim for consistency across jurisdictions but, at the same time, acknowledge the idiosyncratic nature of step-in risk. They therefore allow for banks’ one-off assessments of each case and for the supervisory evaluation of such assessments. To this end, these guidelines entail no automatic Pillar 1 capital or liquidity charge additional to the existing Basel standards. Rather, they provide banks and supervisors with a method for identifying step-in risk and with a list of possible responses that leverage existing prudential tools by informing or supplementing them. Banks are responsible for choosing the most appropriate response once step-in risk is identified, while the role of supervisors is to check and challenge the bank’s response as necessary.

This section defines the entities and relationships that banks should consider for the purpose of this chapter.

Unconsolidated entities

The scope of application of this chapter includes any unconsolidated entities. The scope of regulatory consolidation might differ from the accounting scope of consolidation. Differences between the accounting and regulatory scopes may arise from: (i) the types of entity that should be included within each scope; and (ii) the required method of consolidation. Unless otherwise noted, entities included in the scope of accounting consolidation but excluded from the regulatory scope of consolidation should be subject to the assessment. For the purposes of these guidelines, all entities that a banking group has consolidated for accounting purposes by using the equity method or proportionate consolidation should be subject to a step-in risk review. For example, a joint venture included in the bank’s balance sheet via the equity method or proportionate consolidation is not considered to be consolidated and should be evaluated.

Types of entity

Step-in risk could involve a variety of entities. However, there is neither a commonly established definition nor a comprehensive list of entities in this category. As a result, there is no prescribed list of entity types that should be subject to the identification and assessment. As a minimum, banks are expected to scrutinise securitisation vehicles, investment funds and other entities. Illustrative entity categories include:3

1. entities issuing residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) or other assets (ie credit cards, auto loans);
2. entities issuing covered bonds;
3. entities issuing collateralised debt obligations (CDOs) and collateralised loan obligations (CLOs), including cash CDOs and synthetic CDOs;
4. entities issuing tender option bonds (TOBs);
5. entities issuing asset-backed commercial paper (ABCP);
6. securities arbitrage conduits;
7. structured investment vehicles (SIVs);
8. repackaging vehicles;
9. real estate investment trusts;
10. mutual funds, including money market funds (and equivalent mutual funds in other jurisdictions) and exchange-traded funds;
11. hedge funds;
12. private equity funds;
13. finance companies; and
14. securities firms.

Relationships between the bank and the entity that prompt inclusion in the initial set of entities

A bank is not required to evaluate all entities with which it has a relationship, but those where it has one or more of the following relationships with an entity: sponsor, debt or equity investor, and/or other contractual and non-contractual involvement.

Specific entities and cases

Insurance entities are specifically excluded from the regulatory scope of consolidation and attract a specific prudential treatment. They are therefore presumed not to be included within the types of entity considered in this chapter. The same applies to regulated banking entities supervised by banking supervisors which are already subject to specific prudential treatment.

Asset management companies and the associated assets under management that are not consolidated for regulatory purposes may bear step-in risk for the banks. Those should therefore not be excluded a priori from the identification process.

Securitisation entities are within the scope of this chapter. When the securitised assets of a vehicle meet operational requirements for the recognition of significant risk transfer (SRT), the bank still needs to assess the step-in risk associated with such an entity since non-contractual step-in risks might remain under specific circumstances. The SRT criteria focus on credit risk transfer and may ignore other risk factors considered in the step-in risk framework. The existing prudential treatment of the securitised assets that meet SRT criteria for risk-based capital requirement and Basel III leverage ratio measure purposes are not modified by this provision.

Commercial entities (ie non-financial) may generally be excluded from the step-in risk analysis. However, a commercial entity that provides critical operational service(s) to the bank and cannot be substituted in a timely fashion or without excessive costs should be considered, in line with the bank’s recovery and resolution plan. Supervisors should require, at a minimum, that such entities to which the bank is the sole customer be considered. A non-financial undertaking bearing significant bank-like risk for the bank should be considered in the scope of this chapter.

An entity may be excluded from the step-in risk analysis if, given its size, stepping in to support it would not significantly impact the bank’s liquidity and/or capital positions. To that end, a bank should establish its own internal policy for determining materiality, subject to supervisory review. This materiality policy should consider both the liquidity and capital requirements that would arise from stepping in to support the entity as well as the broader adverse consequences of not stepping in. In performing the materiality evaluation, similar entities should be evaluated in aggregate. This is because the step-in risk might be significant when considering the “contagion” risk to similar entities, even when the step-in risk seems insignificant for a single entity. Entities considered as immaterial for step-in risk purposes should still be subject to aggregate reporting to the supervisor.

National authorities may explicitly prohibit banks from stepping in to support certain entities. In such cases, the banks are not required to analyse or report the step-in risk associated with such entities.

Only a law or regulation which is clearly enforceable, of general application and which explicitly prohibits the provision of support, can be considered as a collective rebuttal. If there are legislative changes, so that regulations that provided the basis for the exclusion no longer apply, the step-in risk guidelines should be applied immediately after the changes. The bank should specify in its policies and procedures the types of entity excluded due to a collective rebuttal and keep a list of such entities available on supervisory request. However, entities excluded due to a collective rebuttal do not have to be reported to the supervisor on a regular basis.

Contract law or industry standards on their own are not to be considered eligible for collective rebuttal, and the prohibition must not vary based on a bank’s capital or liquidity position and planning process or risk management approach.

The initial set of entities to be scrutinised should be assessed against the indicators listed below. In performing the evaluation, the bank should focus on the purpose and design of the entity, considering in particular the relevant activities carried out and administered by the entity, how decisions about those activities are made, who has the current ability to direct those activities, the bank’s relationships (contractual or otherwise) with the entity, and who is entitled to contractually receive the expected returns or is otherwise exposed to the risks of the entity.

The indicators are not ordered by importance, nor should they be considered exhaustive; all indicators, including the additional or adapted ones, are nonetheless necessary to appropriately evaluate specific structures. Generally, all the indicators need to be considered in combination to reach a conclusion. However, in certain situations, one indicator alone may be sufficient to trigger the identification of step-in risk. Similarly, the examples and counterexamples for individual indicators are meant to be illustrative rather than determinative.

In its role as sponsor, the bank may be exposed to a greater degree of step-in risk in certain cases, such as when it: (i) provides full sponsor support,4 via a guarantee or other credit enhancement; or (ii) provides partial credit enhancements and liquidity facilities while playing a role in decision-making.

Examples: The bank is a full sponsor of an entity. The bank provides partial upfront facilities to an entity where the bank is also, to a relevant degree, a decision-maker.

This indicator is not meant to be synonymous with the accounting notion of power/control that is a prerequisite for accounting consolidation but rather a lower threshold (eg significant influence). A greater degree of influence over an entity may be indicative of a greater incentive to step in during a time of financial stress.

Examples: Capital ties < 50% and power to exercise a significant influence over the management. Capital ties > 50% but no regulatory consolidation. No capital ties but ability to remove and appoint board of directors. In the case of SPEs (including “autopilot” vehicles), existence of organisational and financial relationships that effectively transfer to the bank most of the risks and/or benefits of the vehicle’s activities.

Counterexample: The bank is merely an agent, making decisions subject to a contractual mandate, and has no other exposure to the entity’s variable returns. This does not preclude the bank from assessing other indicators, as other indicators might point to the existence of step-in risk.

This indicator considers whether the bank is providing an implicit guarantee, for instance in investors’ rate of return expectations. For instance, the bank would evaluate, by comparison with other similar entities, whether the investor is accepting a lower rate of return on its investment relative to risk, potentially indicating that the investor expects the sponsoring bank to support the entity in a stress scenario. This indicator should also consider the entity’s credit rating, whether assigned by a third-party rating agency or internally by the bank, and specifically the extent to which the entity’s rating is dependent on the bank’s and/or parent company’s credit rating.

Examples: Entities which are assigned a better rating than would have been the case without considering the relationship with the bank (ie the entity’s rating is reliant on the bank’s or parent company’s rating to an extent that exceeds a contractual arrangement). Entities where the rate of return accepted by investors is materially lower than what is indicated by the risks of the entity’s assets.

An entity may be highly leveraged at its inception relative to the risks associated with the assets it holds. These entities can be characterised by control being exercised through means other than traditional voting rights. Although these entities are already evaluated under accounting consolidation requirements, this indicator is meant to highlight that these types of entity are more prone to step-in risk than adequately capitalised entities.

Examples: Structured vehicles under IFRS and variable interest entities under US GAAP, or comparable entities under relevant accounting regime.

This indicator refers to entities with a limited capacity to access liquidity when facing an unanticipated increase in redemption requests (ie they cannot sell enough assets to meet the redemption) and which would therefore impact the bank’s liquidity should it conclude that it must provide step-in support. This would include situations where long-term assets are funded with short-term liabilities (ie maturity mismatch). All else equal, off-balance sheet entities that engage in maturity transformation by holding non-risk-free assets (ie those other than sovereign-backed bonds) increase the potential for step-in. Entities holding large cash reserves or HQLA equivalents for regulatory reasons would be less likely to increase step-in risk because their increased liquidity needs during stress periods would already be covered, at least in part.

As a corollary to liquidity concerns, liability run risks are heightened when it is advantageous for an investor to exit the entity before others do. This scenario is more acute when there are no potential barriers to redemptions (ie redemption gates). Also of note are entities whose performance depends on an illiquid benchmark and which are hence more prone to volatile valuations and large drops in value during periods of liquidity stress (eg emerging market equity index funds, corporate bond funds and high- yield bond funds).

Examples: Structured investment vehicles (SIVs) during the financial crisis were particularly prone to investor runs. Funds redeemable at constant net asset values (NAV). Funds that do not exercise any type of redemption penalty (eg redemption fees, swing prices). Significant mismatch between asset and liability maturities.

Counterexamples: Index funds. Passive investment funds (eg exchange-traded funds (ETFs)). Funds that have floating/variable NAVs (eg open-end mutual funds). Funds with substantial redemption costs or the legal ability to impose redemption gates. Pass-through securitisations. Separately managed/segregated funds (ie funds that legally have only a single customer).

This indicator refers to an entity’s degree of transparency, and the extent to which investors are provided with detailed information that allows them to understand and assess its risk-adjusted returns. Disclosures can also be made to investors within investment offering documents (ie in an investment prospectus) regarding any restrictions on the bank’s contractual obligations to support the entity.

Examples: Entities where the risk in underlying investments is opaque. Entities that cannot be rated or where the rating depends on a range of unsupported assumptions. Entities with a return that depends on indirect factors which are difficult to quantify.

Counterexamples: Entities subject to a robust disclosure regime under a regulatory regime that sets out the risks to be absorbed by investors. Entities that provide clear and frequently updated disclosure of their assets and liabilities.

Accounting disclosure requirements can provide meaningful information to evaluate the nature and risks of a bank’s involvement with unconsolidated entities.

Examples: Exposures to unconsolidated entities disclosed under IFRS 12 or US GAAP VIE disclosures, or comparable disclosures made under the relevant accounting regime. US GAAP disclosures associated with constant-NAV money market funds. Contingent liabilities that meet disclosure requirements but do not meet the loss recognition thresholds under accounting standards.

Counterexamples: Exposures already recognised in capital through recognition of associated contingent liabilities, with associated reduction in capital.

This indicator refers to entities whose activities do not sufficiently match the risk profiles of their clients/investors with those of the risk exposures of the entity. This risk is not restricted to the narrow case of mis-selling (if such a concept exists in a given jurisdiction); rather, a broad analysis is required of whether the entity’s risk exposures are aligned with investors’ risk appetites.

Examples: Funds that mix different term and/or wealth expectations into a single fund type. Banks that provide investment products to investors who are loss-averse (confidence-sensitive products). Instances where investors have not received any proper explanation of risks (eg mis-selling). Banks selling to retail customers products that have bundled, hard-to-price features (eg subordinated debt, preferred shares, debt instruments with embedded optionality).

Counterexamples: Entities in jurisdictions where banks are obliged by law to ensure that particular investment products are appropriate and correspond to the needs of the investors to whom they are sold.

This indicator refers to the potential harm to a bank’s reputation when an entity has clients in common with the bank and carries the bank’s brand (eg corporate name, logo/symbol). Different brand strategies create different risk profiles.

Branding could strengthen the presumption of step-in support, especially if the brand is associated with a bank in the same banking group. A distinction could be made between a “branded house” strategy and a “house of brands” strategy. Under the branded house strategy, the bank maintains a corporate master brand that acts as a single unifying banner, source of reputation and federating force for all product and service offerings. In a house of brands strategy, a bank operates through an independent set of standalone brands while keeping the corporate brand itself discrete. To the extent that a branded house strategy aggregates numerous products and business lines, it can be associated with a higher incentive for the bank to step in should one of its products or businesses be compromised, to protect its reputation and brand.

The evaluation of this indicator should consider the degree to which cross-selling is part of the bank’s overall strategy, as a greater degree of cross-selling increases reputational risk and, thus, the incentive to provide step-in support. This is particularly the case if a bank or banking group has standalone deposit-taking institution(s), broker-dealer(s) and asset management unit(s) that cross-sell products.

Examples: Banks that aggressively and successfully cross-sell both on- and off-balance sheet products to their key clients. Banks that use a branded house strategy, where the brand is attached to the entity.

This indicator refers to documented instances where step-in support has been provided previously to specific types of entity.

Example: Step-in support was provided to money market mutual funds and SIVs during the financial crisis.

This indicator refers to banking, securities, market or other financial regulations that restrict, without prohibiting, a bank’s ability and/or propensity to support an entity on terms that are unfavourable to the bank.

Examples: Entities for which higher capital requirements are set in order to cover potential step-in situations (in the EU Capital Requirements Regulation, for example, the calculation of own funds requirements for operational risk includes reputational risk, which may be taken into account, provided that the bank can demonstrate and document that the specific step-in risk identified enters into the calculation of requirements). Entities where a step-in action would be subject to the Federal Reserve Act 23A and 23B (Regulation W).5

A bank’s approach to step-in risk management and measurement should be sensitive to residual risk, ie after accounting for possible risk mitigants. Banks should consider the degree and effectiveness of any mitigants for step-in risk, including the scope for mitigants to reduce the potential impact on the bank if step-in risk support were provided.

The bank’s risk measurement and management process should be designed to ensure that the bank has adequate resources available in advance of potential step-in support, which would thus reduce the procyclicality of such stress. The aim is to avoid a situation where unanticipated support provided by a bank weakens the bank’s ability to meet its own contractual commitments and its liquidity and/or capital requirements.

When a bank identifies significant step-in risk to an entity, it can apply a range of potential risk measurement and management measures (see below). Banks can determine the appropriate choice of measure(s) (subject to potential supervisory scrutiny), based on the nature and extent of the anticipated step-in support in each case.

As part of their risk management processes, banks should establish and maintain policies and procedures to identify and assess step-in risk. These policies and procedures should:

1. Clearly describe the identification criteria that banks use to identify the step-in, which should include, at a minimum, the indicators described above.
2. Not be prescriptive or geared towards any particular type of entity.
3. Clearly describe the specific provisions of the laws or regulations acting as collective rebuttals and list the types of entity covered by those laws or regulations.
4. Describe the internal parties responsible for identifying, monitoring, assessing, mitigating and managing the potential step-in risk.
5. Clearly describe the bank’s own definition and criteria of “materiality”, as used to exclude immaterial entities in the bank’s step-in risk assessment, and their rationale.
6. Document the process to obtain the necessary information to conduct the regular self- assessments.
7. Be reviewed regularly, and whenever there is any material change in the types of entity or in the risk profile of entities. If there have been no material changes, the policies and procedures should be reviewed in accordance with the bank’s own policy on frequency of review of key policy documents, or at least every three years.
8. Require the step-in risk self-assessment to be included in the internal risk management processes, subject to independent controls, and to be discussed by the appropriate risk committee of the bank’s board (or similar organisation) as a separate agenda item.
9. Be documented and available for supervisory review upon request.

In accordance with their policies and procedures, banks must regularly identify all entities giving rise to step-in risk. For all relevant entities, banks should estimate the potential impact of step-in risk on their liquidity and capital positions. The bank should use the estimation method it considers most appropriate, recognising that this may be influenced by the potential responses to step-in risk.6 Banks should describe the method used to estimate the financial impact of step-in risk in each case.

Banks must regularly report the results of their self-assessment of step-in risk to their supervisor. This report can be part of an existing supervisory process or a standalone step-in risk report, as long as it appropriately serves the purpose of these guidelines and provides the expected information. The expectation is that this reporting becomes mandatory and should be submitted annually.7

Where a bank already has substantial contractual obligations to provide support to another entity at a time of stress, augmented by a significant risk that the bank would go beyond these contractual obligations, inclusion of the entity in the regulatory scope of consolidation may be the most appropriate measure, particularly where the entity’s balance sheet structure and activities are amenable to banking regulations.

Inclusion in the regulatory scope of consolidation may be used, considering the following aspects:

1. The entity appears to have been designed to specifically avoid regulatory consolidation (or exhibits characteristics common to entities that are used to arbitrage regulatory requirements).
2. There have been previous and documented step-in cases in similar circumstances.
3. There are organisational and financial relations that, in substance, assign the majority of the risks and/or of the benefits arising from the activities of the entities to the bank.
4. There is investor expectation of full or significant support during a stress period.
5. There is an expectation that the nature and extent of step-in support would trigger accounting consolidation of the entity and, consequently, the inclusion of the entity in the regulatory scope of consolidation.

The cases above would generate a strong presumption that consolidation ought to be applied. However, the expectation is that such cases should be limited in practice. This treatment could be considered as a backstop addressing issues related to the incomplete implementation of existing accounting and regulatory frameworks.

This measure might not be appropriate when consolidation would artificially improve the capital or liquidity position of the bank, because the entity’s resources might not be available to the bank.

Depending on the jurisdiction, the inclusion of a given entity could occur in the accounting scope of consolidation8 or in the regulatory scope of consolidation.

Provided that the entity’s leverage and asset and liability composition can be captured in regulatory metrics, this measure would be implementable. It does not require any further quantification of the step-in risk because the risk is essentially addressed through the entity’s consolidation.

Consolidation would have an impact on all regulatory metrics that use the regulatory scope of consolidation as a starting point (ie capital requirements, leverage ratio, liquidity requirements, large exposures, G-SIB identification). It will essentially exclude the use of any other measure.

When significant step-in risk exists but consolidation would not be appropriate, using a conversion factor to estimate the risk might be appropriate. For instance, the conversion approach might be appropriate in cases where the bank’s anticipated step-in support includes the provision of a liquidity facility up to some portion of the entity’s liabilities. A conversion factor could be applied to the entity’s exposures and used to determine a response in terms of increased capital requirements and/or liquidity requirements.

The degree of step-in risk may differ substantially depending on the entity’s design and related transactions. A bank (or supervisor) should be able determine an appropriate conversion factor and apply it to a specific set of circumstances, since neither a uniform “one size fits all” conversion factor nor full consolidation may be sufficiently case-/risk-sensitive. This flexible approach is simple to implement, with only a few data requirements. A relatively high conversion factor could be assigned in cases where the impact on the bank of stepping in is deemed high, whereas a relatively low conversion factor could be assigned where step-in risks would have less impact.

Banks and supervisors should adjust this measure so that it is consistent with the step-in risk guidelines applicable in their jurisdiction. A further challenge relates to measuring any risk that is not tied to a contractual exposure.

The starting point of this measurement is to convert the total assets of the unconsolidated entity and its off-balance sheet exposures into asset equivalents as a single figure. This figure could then be adjusted by subtracting the amount of any assets held by the entity in the banking group and the amount of any off-balance sheet exposures (assets) held by the banking group in the entity that already give rise to a capital charge or a capital deduction and or to a liquidity cash outflow. The resulting sum is then subject to a conversion factor, similar to off-balance sheet items.

Such a method provides a measure that could be used to reflect the potential impact of step-in on the bank’s regulatory capital requirements (eg by assigning a conversion factor to this amount) but also, where appropriate, to reflect the potential impact of step-in risk on the bank’s liquidity requirement (eg by assigning a certain cash outflow rate to this amount).

The existing provisions in the liquidity standards could be used to account for step-in risk and better reflect the outcome of the step-in risk assessment. To apply the existing provisions, banks and supervisors should first identify the non-contractual obligations; for this purpose, the identification method for step-in risk is relevant. Liquidity regulations require the measurement of “contingent funding obligations [that] may be either contractual or non-contractual and are not lending commitments…”.

1. The LCR contains several paragraphs (see LCR40.68 to LCR40.70) that address the potential need for the bank to buy back debt or honour non-contractual obligations to mitigate reputational risk. However, the LCR does not prescribe the methods for identifying such step-in risks.
2. The NSFR requires stable funding factors for off-balance sheet exposures (see NSF30.33 and NSF30.34 and Table 3). Off-balance sheet exposures include non-contractual obligations, which could be identified through the step-in risk assessment. The NSFR allows national supervisors discretion to determine the required stable funding factors for other contingent funding obligations, such as potential requests for debt repurchases of conduits, securities investment vehicles and similar financing facilities; structured products where customers anticipate ready marketability; and management funds marketed with the aim of maintaining a stable value.

Banks and supervisors may decide to include in their stress-testing framework entities that are not part of the regulatory scope of consolidation of the banking group. The main aim of this approach is to ensure that any procyclical effects are covered by ex-ante capital holdings (and, where appropriate, liquidity), even in regimes that do not use Pillar 2 capital charges. This can lead to an evaluation of the potential impact of banks’ relationships with unconsolidated entities on their financial resources in market stress tests or scenario analysis.9 The results of such stress testing and scenario analysis would be expected to help a bank consider whether it needs additional capital or liquidity in respect of these unconsolidated entities, and to highlight whether specific measures should be taken to mitigate adverse effects if the risks covered by the stress or scenario test materialise.

Banks and supervisors might leverage the accounting framework for provisioning to measure the impact of a step-in event. For instance, this might take the form of estimating the potential cash outflows resulting from a step-in, and assessing them against the expected fire sale value of the entity’s assets. This method could potentially be compared with the conversion approach described above. However, the practical implementation would result in a deduction from CET1 (as is the case for prudent valuation adjustments, for example) rather than an increase in the appropriate capital charge.

Punitive ex post capital charges

A supervisor may apply a punitive capital charge after a bank steps in to support an entity beyond its contractual obligations (ie ex post). Supervisors may use this approach as a way of reducing step-in risk by deterring banks from stepping in. The supervisor might need to require either that the post-step-in exposure be risk-weighted at a considerably higher level than under the default rules, or that the entity’s total assets be brought onto the bank’s balance sheet at the prevailing risk weight (ie similar to the conversion approach outlined above). Supervisors would, however, need to consider whether such a measure would clash with the objective of reducing procyclical effects. However, this would be balanced against the fact that it would incentivise banks to identify and assess their step-in risks. This would particularly be the case if supervisors established it as a credible prudential measure through its consistent use in cases where banks step in to provide support to unconsolidated entities.

Large exposure-like internal limit

This specific measure builds upon the large exposures requirements in the Basel Framework (LEX). It requires a bank to apply an internal limit to all of its contractual exposures and/or estimation of step-in risk to NBFI entities. Such an approach can be useful to limit banks’ concentration risk vis-à-vis NBFI entities.

Disclosure

To mitigate step-in risk through strengthened market discipline, banks and supervisors may also require specific public disclosures, such as the number, size and nature of unconsolidated entities in terms of step-in risk, and of banks’ own risk assessment and their management of such exposures. As a potential downside, public disclosures might cause “self-fulfilling prophecies” or moral hazard, as market participants could interpret them as implying that a requirement exists to step in to provide support even where there is no contractual commitment to do so. However, this risk could be mitigated if banks make it clear that step-in risk disclosure does not imply any commitment to step in if an unconsolidated entity finds itself in distress. This tool would be expected to complement one of the measures described above rather than being used in isolation.

Review of banks’ policies and procedures

At a frequency to be determined, supervisors may request a bank’s step-in risk identification and assessment policies and procedures and assess banks, for example, on some or all of the following items:

1. Adequacy and quality of policies and process for the identification, assessment, management and control of step-in risk.
2. Adequacy of the internal policy to determine materiality and criteria used to this end.
3. Adequacy of risk management and measurement system (eg ability to keep track of the unconsolidated entities on a timely basis).
4. Integrity of management information systems.
5. Conceptual soundness of internal capital and liquidity assessment and adequacy processes.
6. Soundness of internal controls and internal audit, and any findings of internal controls and internal audit with regard to step-in risk assessment.
7. Previous provision of step-in support to entities, particularly to those which are still extant and are still subject to the same regulatory regime as during the previous period of step-in support.

In reviewing a bank’s policies or procedures, supervisors may make use of its internal findings, including those from the bank’s internal control or audit areas.

Supervisors are expected to review banks’ policies or procedures to ensure that banks have conducted appropriate self-assessment of the eligible collective rebuttal presumptions, including the appropriate interpretation and application of relevant laws and regulations. In addition to these collective rebuttals, banks may also provide evidence that the step-in risk to a particular entity has been mitigated.

Supervisors are also expected to review the banks’ policies and procedures about “materiality’” criteria to ensure that they are reasonable, conservative and appropriately applied.

Review of banks’ regular step-in risk self-assessments and remedial actions

Regardless of the frequency, granularity or format of the regulatory reporting requirements, banks should regularly assess step-in risk.

When reviewing a bank’s assessment of step-in risk, a supervisor will consider each particular case and its specific features as a one-off assessment. The supervisor will exercise judgment in each case based on the bank’s presentation of the facts. If the supervisory assessment reveals that significant residual step-in risks have not been appropriately estimated or mitigated, a supervisor may use the measures that it determines appropriate in the circumstances. The choice of measures will be based on the nature and extent of step-in risks, accounting for the probability and magnitude of step-in risk and the reliability of estimating it. Supervisors should be additionally concerned if the assessed risk could have group-wide or systemic implications.

Supervisors can use reporting to assess the adequacy of banks’ self-assessment and the magnitude of residual step-in risk identified. Supervisors should evaluate whether step-in risk assessments are consistent across banks/jurisdictions or whether certain types of off-balance sheet activity are increasing in frequency and volume. This will help them identify emerging firm-specific and systemic risks.

Supervisors should have the authority to ask banks to remedy any deficiencies in their risk management approach, although the specific supervisory action will vary according to the circumstances.

Cooperation and exchange of information

Home and host supervisors should share information with each other regarding the supervision of step-in risk for banking groups with branches or subsidiaries across multiple jurisdictions. Such information sharing could take place on a bilateral or multilateral basis (eg through supervisory colleges), using data obtained from the regulatory templates. The information shared could include supervisory experiences from assessing and monitoring a bank’s step-in risk identification and risk management in different parts of its group, banks’ estimation methods, any impediments to the supervision process, rules/criteria for evaluating banks’ responses and examples of good practice observed in banks’ management of step-in risk.