II Banks’ Involvement with HLIs and their Overall Credit Risk Strategy
No: 191000000710
Date(g): 9/3/1999 | Date(h): 22/11/1419
Status: In-Force
Before conducting business with HLIs, a bank should establish clear policies that govern its involvement with these institutions consistent with its overall credit risk strategy. Banks should ensure that an adequate level of risk management, consistent with their involvement with HLIs, is in place.
In general terms, each bank should have in place a clear credit risk strategy and an effective credit risk management process approved by the board of directors and implemented by senior management. The credit risk strategy should define the bank’s risk appetite, its desired risk return trade-off and mix of products and markets. In this context, a bank should assess whether dealings with HLIs are consistent with its credit risk strategy, its risk appetite and its diversification targets. If so, policies and procedures for interactions with HLIs must be devised that establish effective monitoring and control of such relationships. These policies and procedures should drive the credit setting process and govern banks’ relationships with HLIs, and should not be overridden by competitive pressures.
An effective credit risk management process includes appropriate documentation, comprehensive financial information, effective due diligence, use of risk mitigants such as collateral and covenants, methodologies for measuring current and future exposure, effective limit setting procedures, and ongoing monitoring of both the firm’s exposure to and the changing risk profile of the counterparty. Upholding these standards is particularly important with respect to interactions with HLI counterparties, where information has been limited, leverage may be high and risk profiles can alter rapidly. Where credit concerns are identified with regard to an HLI, a bank should either not conduct business or take appropriate steps to limit and manage the exposure consistent with their overall underwriting standards and risk appetite. HLIs that provide either insufficient information to allow meaningful credit assessments or proportionately less information about their risk profile than other counterparties should face tougher credit conditions, including, for instance, a higher level of initial margin, no loss threshold, a narrower range of assets which are deemed acceptable for collateral purposes, and a stricter range of other financial covenants.
The long-term success of a bank’s credit relationships relies heavily on effective and sophisticated risk management. This applies to banks that assume credit risks arising out of derivatives and other trading transactions with HLIs such as repurchase agreements and securities lending, as well as to banks that commit funds to HLIs through loans, credit lines or equity participations. Assuming credit exposure implies counterparty monitoring commensurate with the size of the exposure. Effective monitoring of the activities of an HLI requires thorough knowledge and understanding of its trading strategies, exposure levels, risk concentrations and risk controls. Reliance on collateral cannot substitute for day-to-day risk management and monitoring. While it can help reduce counterparty credit risk, full collateralisation of mark-to-market positions does not eliminate exposure to secondary risks (such as declines in the value of securities pledged as collateral) from a volatile market environment that could follow the default or disorderly liquidation of a major HLI. Moreover, collateral cannot fully mitigate credit risk and may add to other risks, such as legal, operational and liquidity risks.
