HLI report - Anniversary Review
25 January 2000
The Basel Committee on Banking Supervision today announced that both banks and supervisors have made progress in responding to the risks posed by Highly Leveraged Institutions (HLIs) following the lessons learnt from the near collapse of Long Term Capital Management in 1998. However, the Committee believes that further efforts are required to lock in and strengthen improvements in banks' risk management approach towards HLIs.
These views are warning was contained in a review by the Committee of the steps banks and supervisors have taken in the year since its paper Sound Practices for Banks' Interactions with Highly Leveraged Institutions was issued. Mr William J McDonough, Chairman of the Basel Committee and President and Chief Executive Officer of the Federal Reserve Bank of New York, welcomed the review, observing that: "It is important that the Committee should assess the response by banks and regulators to the recommendations it made last year, as HLIs can be expected to continue to expand their activities and remain significant players in the financial markets."
The review draws attention to the responses by both banks and supervisors to the Committee's recommendations. Varying degrees of progress have been made with respect to banks' awareness of the potential risks and weaknesses in dealing with HLIs, due diligence in their credit policies for such institutions, collateral management arrangements and risk measurement practices. These improvements play a critical role in the reduction of the potential risks posed to the financial system by the activities of HLIs. Supervisory authorities have taken various steps to inform the banking institutions under their jurisdiction of the Basel Committee's concerns and recommendations. Some supervisors, particularly in those countries where banks have significant dealings with HLIs, have included a review of banks' risk management policies and practices with respect to HLIs in their regular on-site examinations. Some have also requested and obtained detailed exposure information, for instance on banks' lending to HLIs or on their collateralised and uncollateralised exposures arising from derivatives and other transactions with such institutions.
Drawing attention to the need for further work, Mr Jan Brockmeijer, Chairman of the Committee's Working Group on Highly Leveraged Institutions and a member of the Basel Committee, noted: "Although there has been progress in the past year, there remain important areas where further work is needed, both at the industry level and at individual firms. This includes several technical areas such as potential future exposure measurement, collateral management techniques and stress testing."
The report underlines the need for supervisors to continue to reinforce the efforts made by firms and is particularly aware of the need for coordination across sectors in order to achieve this. In this context, the Committee welcomes the report on Hedge Funds and Other Highly Leveraged Institutions by the International Organization of Securities Commissions (IOSCO) that was published in November 1999. The Committee notes that the recommendations regarding prudent practices by regulated securities firms correspond with its own recommendations for banks. Such a common approach is essential to avoid slippage of prudent practices due to competitive pressures.
In order to maintain momentum, it is proposed that representatives of the Basel Committee meet with members of the IOSCO Task Force on HLIs to establish common areas of interest in risk management practices of banks and securities firms in respect of their dealings with HLIs. The IAIS could also participate in such a meeting if there are particular insurance issues of concern to its members.
This group would then seek periodically, and over a limited time period, to assess industry progress on both difficult technical issues (such as measurement of potential future exposure, liquidity valuation, and stress testing) and in improving risk management processes more generally.
Notes to editors
The Basel Committee on Banking Supervision
The Basel 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 William J McDonough, President and Chief Executive Officer of the Federal Reserve Bank of New York. The Committee usually meets at the Bank for International Settlements (BIS) in Basel, 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 Basel Committee in October 1998, with a mission to analyse 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, comprising supervisory experts from several member institutions and chaired by Mr Jan Brockmeijer, Deputy Director of the Netherlands Bank, has now disbanded and future work on issues related to HLIs will be considered by the Basel Committee's Risk Management Group and other relevant working groups.
What is an HLI?
The Basel Committee acknowledges that it is very difficult to provide a precise definition of an HLI; for purposes of analysis in its January 1999 report, the Committee's 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 recognises that some but not all so-called hedge funds have these characteristics, while many mainstream financial institutions, such as banks and securities houses, exhibit some of them. As such, the report refers to banks' dealings with institutions that pose the particular counterparty risks arising from such characteristics, however they may be classified.
The Committee's previous reports
In response to financial market developments, and as part of its ongoing efforts to encourage prudent risk management practices in banking institutions, the Committee issued in January 1999 two reports, Banks' Interactions with Highly Leveraged Institutions and Sound Practices for Banks' Interactions with Highly Leveraged Institutions, which provides guidance in such dealings. Both reports are available on the BIS website (www.bis.org under "publications").
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 standardise methodologies for measuring potential future exposure.
Where can I obtain the full report?
The text of the report Banks' Interactions with Highly Leveraged Institutions: Implementation of the Basel Committee's Sound Practices Paper can be obtained from the BIS website (www.bis.org under "publications") as of 12 noon (CET) on 25 January 2000. The reports are also available from the Basel Committee's Secretariat at the Bank for International Settlements (e-mail: firstname.lastname@example.org) and from member bank supervisory authorities and central banks.