Preface

No: 16609/BCI/710

Date(g): 9/3/1999 | Date(h): 22/11/1419

Status: In-Force

Effective from Mar 09 1999 - Mar 08 1999
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In recent years, the activities of highly leveraged institutions (HLIs) have grown in both magnitude and complexity. The scope of the interactions between HLIs and mainstream financial institutions, such as banks and securities firms, has also expanded, emphasising the need for a full understanding and management of the risks generated from these activities. As with other borrowers and counterparties, banks and other financial intermediaries play a key role in allocating credit to HLIs. However, in the case of HLIs this can be particularly challenging given the relative opaqueness of their activities, the significant use of leverage and the dynamic nature of their trading positions and, in some cases, their market impact. The Basel Committee on Banking Supervision recognises that not all banks deal with or have significant exposures to HLIs. Most institutions that do have exposures to HLIs appear to be reviewing and tightening their credit standards for HLIs following the near-collapse of the hedge fund LTCM in September 1998. A key motivation for issuing sound practices is to ensure that improvements in credit standards and risk management processes are "locked in” over time and that the lessons are applied to the management of counterparty credit relationships more generally.
The management of credit risk in respect of HLIs involves the same principles as management of credit risk in general, but must also take account of the particular types of counterparty risk associated with such institutions. The Committee will shortly publish general principles for the management of credit risk. This paper should be seen as complementary to that effort, and is a response to the specific challenges posed by credit risk emanating from interactions with HLIs. The Committee’s review of banks’ dealings with HLIs has revealed that in many cases there has not been an appropriate balance among the key elements of the credit risk management process, with an over reliance on collateralisation of mark-to-market exposures.¹ Insufficient weight was placed on in-depth credit analyses of the HLI counterparties involved and the effective measurement and management of exposures. Moreover, in some cases, competitive forces and the desire to conduct business with certain counterparties may have led banks to make exceptions to their firm-wide credit standards.
Counterparty exposures to HLIs can take a variety of forms, including in particular secured and unsecured credits resulting from off-balance-sheet contracts. The characteristics and implications of OTC derivatives were analysed by G-10 central banks in 1994. Following that review, the Committee issued risk management guidelines for derivatives that identified the types and sources of risk to counterparties in OTC transactions and reviewed sound risk management practices for each type of risk. In September 1998, the Committee on Payment and Settlement Systems and the Euro-currency Standing Committee published a report on settlement procedures and counterparty risk management related to OTC derivatives, which provides a thorough analysis of the policies and procedures employed by OTC derivatives dealers. Where appropriate, these guidelines will draw on these earlier studies and apply them, together with other recent insights, to the specific risks posed by highly leveraged counterparties.
The Basel Committee is distributing these sound practice standards to supervisors, banks and other interested parties worldwide with the expectation that they will encourage the further development of prudent approaches to the assessment, measurement and risk management of credit exposures to HLIs. The Committee invites the financial industry to assess standards and practices and to react to the recommendations. The Committee encourages supervisors to promote the application of sound practices by banks in their interactions with HLIs. The Committee wishes to emphasise that sound internal risk management, including effective counterparty credit risk management, is essential to the prudent operations of banks. With respect to their involvement with HLIs, it may also contribute significantly to ensuring that HLIs do not assume excessive risks and leverage. Should a major HLI nevertheless default, sound risk management at the counterparty level could contribute considerably to limiting the destabilising effects on markets resulting from, for example, the rapid deleveraging and liquidation of positions. By helping to reduce the potential for stressed-market exposures, sound credit management and monitoring practices by counterparties of HLIs should contribute to greater stability in the financial system as a whole.

¹ Banks ' interactions with highly leveraged institutions, Basel Committee (BIS), January 1999.