Basel Committee Consults on New Risk-Management Strategy

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International banking supervisor may add step-in risk mitigation to its global agenda.

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As world leaders gathered in Davos for the World Economic Forum‘s annual meeting, one of the world’s leading financial overseers was collecting feedback on a new proposal to address a major banking risk that contributed to the 2008 global financial crisis.

Late last year, the Basel Committee on Banking Supervision, a global standard-setting institution for bank regulation and oversight, issued a request for comments on its proposal to address what is known as step-in risk, or the risk that banks will undermine their solvency by trying to shore up failing non-bank financial institutions.

When a non-bank financial institution affiliated with a bank experiences stress, a sponsoring bank often will lend support in order to avoid the reputational damage that comes from being affiliated with failing institutions. Despite its benefits, this practice can lead to widespread financial instability if the stresses that the non-bank institutions experience spill over into the banking system.

According to the Basel Committee’s consultative document, this spillover threat was a primary cause of the 2008 global financial crisis. After widespread subprime mortgage loan losses rippled through the U.S. economy, rather than suffer reputational loss by allowing their affiliate non-bank entities to fail, many banks offered them financial support and absorbed their losses. This led to a global credit crisis as banks and non-banks depleted their capital reserves and forfeited the liquidity necessary to offer financial services and fund their own operations.

The Committee seeks to prevent similar crises by providing guidance to banks and national regulators on how to identify the unconsolidated entities that banks often support and then better address the potential step-in risks embedded in their financial relationships. The non-bank entities contemplated in the proposal include mortgage and finance companies, funding vehicles, securitization vehicles, money market funds and other investment funds, asset management companies, and commercial entities that provide critical services exclusively to the bank.

The proposal would first call for banks and supervisors to identify and measure primary step-in risk indicators by evaluating their relationships with other entities to determine the degree of “sponsorship” between them, which may indicate the bank’s propensity to provide non-contractual support to unconsolidated entities. This approach considers the decision-making, operational, and financial ties between the entities—the stronger the ties, the greater the step-in risk.

The proposed framework also would call for banks and supervisors to look to other, secondary factors, such as the entities’ branding, the purpose and design of their structure, the composition of their investor base, and more. These secondary factors would help regulators scrutinize a bank’s claim that it does not pose step-in risks.

Furthermore, the document calls for supervisors to provide additional monitoring in five major policy areas:

  1. mitigating risks in banks’ interactions with shadow banking entities;
  2. reducing the risk of “runs” to affect money market funds;
  3. improving transparency and aligning incentives in securitization;
  4. dampening other financial stability risks in securities financing transactions such as repos and securities lending; and
  5. assessing and mitigating financial stability risks posed by other shadow banking entities and activities.

Notably, the Basel Committee proposal currently does not provide specific capital reserve requirements, but instead suggests that national regulators set their own standards based on this more complete information.

The Committee plans to conduct a quantitative impact study to collect evidence on the state of step-in risk today, and then eventually to be able to assess the potential impacts of their own proposals.

The consultative document is preliminary and the Committee soon will decide how the proposals would be incorporated into an overall supervisory framework. Comments are due by March 17th.