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III Information Gathering, Due Diligence and Credit Analysis of HLIs
No: 191000000710
Date(g): 9/3/1999 | Date(h): 22/11/1419
Status: In-Force
A bank that deals with HLIs should employ sound and well-defined credit standards which address the specific risks associated with HLIs.
An effective credit approval process is the first line of defence against excessive counterparty credit risk. It should be a general requirement but one which assumes increasing importance with the size and/or risk of the counterparty relationship. A sound credit approval process for HLIs should begin with comprehensive financial and other information, providing a clear picture of a counterparty’s risk profile and risk management standards. The credit process should identify the purpose and structure of the transactions for which approval is requested and provide a forward-looking analysis of the repayment capacity based on various scenarios. Credit standards should articulate policy regarding the use and nature of collateral arrangements and the application of contractual provisions designed to protect the bank in the event of changes in the future risk profile of the counterparty such as covenants and close-out provisions (Section VI). Moreover, credit standards should set a clear methodology and process for establishing limits (Sections IV and V).
Before entering into any new relationship with an HLI, a bank must become familiar with the counterparty and be confident that it is dealing with an institution of sound repute and creditworthiness. This can be achieved in a number of ways, including asking for references from known parties, accessing credit registers, evaluating legal status, and becoming knowledgeable about the individuals responsible for managing the institution by, for example, checking their personal references and financial state. Banks must also have a clear view about the stability of the HLI, in terms not only of tangible factors such as earnings but also of less tangible ones such as strategy, quality of risk management practices, and staff composition and turnover. However, a bank should not grant credit solely because the counterparty, or key members of its management, are familiar to the bank or are perceived to be highly reputable.
Before establishing a credit relationship with an HLI, a bank should ensure that all information relevant to that relationship will be available to the bank on a sufficiently timely and ongoing basis. Stipulating the conditions in advance for an adequate transfer of information lays the foundation for an appropriate monitoring of credit risk and for assessing the potential need for adjustments to non-price terms or the application of termination provisions. Banks should seek to obtain information about material developments such as changes in the general direction of trading activities, profit and loss developments, significant changes to leverage, alterations to the risk management procedures or the risk measurement process and changes in key personnel. In order to secure the necessary information, banks must in turn satisfy their HLI counterparties that they have in place effective procedures to ensure the confidentiality of the information obtained through the credit review process.
Banks should obtain comprehensive financial information about an HLI; covering both on and off-balance-sheet positions, to understand the overall risk profile of the institution. Although additional efforts may be necessary to develop effective measures of leverage that relate capital to a common denominator of risk across on and off-balance-sheet positions, a starting point could be some measure of firm-wide value-at-risk (VaR), supplemented with the results of realistic stress testing. It is important that, where this information is used, the bank understand the parameters and the assumptions used in arriving at measures of risk and leverage in order to check the plausibility of the VaR and stress testing results. The bank should establish a clear understanding of the quality and integrity of the HLI’s processes and operations for measuring, managing and controlling market, credit and liquidity risks, including back-office systems, accounting and valuation policies and methodologies. The bank should also obtain information about the HLI’s liquidity profile, such as committed lines of credit and the availability of liquid, unpledged assets to meet possible increases in margin calls under adverse market conditions. Banks should periodically confirm, in various scenarios, whether the HLI’s future repayment capacity is reasonably assured or, for instance, highly dependent on specific assumptions.
Comprehensive and current financial information about an HLI is essential for an effective analysis of the counterparty’s credit quality and prudent setting of an internal rating and, consequently, the credit limits granted to the institution and the credit enhancements applied to the relationship. Credit assessment of HLIs and the monitoring and control of the associated counterparty risks are a more complex and time-consuming activity than credit management in respect of other conventional counterparties. It entails a high level of skill and a willingness to devote resources to regular updating and monitoring, resulting in costs which banks must recognise as part of doing business prudently with such institutions.
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