Review of Issues Relating to Highly Leveraged Institutions (HLIs)
The Basel Committee on Banking Supervision and the International Organization of Securities Commissions (IOSCO) today published a review of issues related to banks' and securities firms' dealings with Highly Leveraged Institutions (HLIs). The report represents a follow-up to the reports published by the Basel Committee and the IOSCO Technical Committee in 1999.
Welcoming the report, William J McDonough, Chairman of the Basel Committee and President and Chief Executive Officer of the Federal Reserve Bank of New York, said `The joint HLI working group is encouraged by firms' progress in implementing the HLI Sound Practice recommendations made by the Basel Committee and IOSCO. Senior managements at many firms have strengthened their oversight of HLI activities through improved policies and a clearer definition of overall risk appetites.' He warned, however, that there is no room for complacency on the part of either firms or supervisors in noting: `Notwithstanding these advances, the Working Group has identified a number of areas where additional progress by both individual firms and the industry as a whole is needed. It remains particularly important that firms continue to enhance their exposure measurement methodologies.'
David Brown, Chairman of the IOSCO Technical Committee and Chairman of the Ontario Securities Commission also welcomed the report: `Despite a number of recent changes in the HLI sector, the sound practices outlined in the earlier Basel and IOSCO reports remain valid. The report emphasises the importance of firms keeping their risk management practices in respect of HLIs under close scrutiny to ensure that they have in place a `package' of measures for monitoring and mitigating the risks involved.'
An important aspect of the relationship between HLIs and authorised firms is the timely flow of relevant information between counterparties and the appropriate management of the exposure in the light of this information. Paul Wright, co-chairman of the HLI Working Group and Chairman of the IOSCO Working Party on the Regulation of Financial Intermediaries explained that: `While the availability of information from HLI counterparties has improved over the last two years, progress has been inconsistent, particularly in the provision of quantitative information. Similarly, while firms have generally been able to strengthen contractual provisions with respect to the HLI sector, competitive pressures continue to affect firms' ability to insist on the full range of risk mitigants.'
The assessment of exposure to HLIs is a topic that the Working Group has identified as requiring further attention. Stefan Walter, co-chairman of the Working Group and a member of the Basel Committee's Risk Management group described the need for further technical work in this regard, noting that `While firms have made significant progress in strengthening their measures of potential future exposure, efforts to conduct regular and comprehensive stress testing have progressed more slowly. It is important that firms devote the necessary resources to enhancing their stress testing capabilities for assessing the combined impact of large market moves, counterparty credit exposures and collateral values.'
Notes for editors
In January 1999, the Basel Committee on Banking Supervision issued a report on Banks' Interactions with Highly Leveraged Institutions (HLIs).1 This evaluated the quality of banks' risk management practices toward HLIs and related supervisory and regulatory issues. The Basel Committee has also published guidance on Sound Practices relating to banks' interactions with HLIs.2 The Technical Committee of IOSCO also produced a report on securities firms' interactions with HLIs in November 1999.3 The nature of these interactions, the risks and the recommendations for sound practices in mitigating these were very similar to those identified for banks.
During 1999, the Basel Committee, through its Working Group on Highly Leveraged Institutions, focused on monitoring the implementation of the Sound Practices paper and published a review of compliance with its Sound Practices in early 20004. That paper outlined a series of issues relating to HLIs which required further attention from banks, supervisors, and international groups. It also proposed continued collaboration between bank and securities firm regulators and ongoing dialogue with the financial industry, particularly in challenging technical areas such as measurement of potential future credit exposure and stress testing. Accordingly, a joint Basel/IOSCO Highly Leveraged Institutions' Working Group (HLIWG) was established in the spring of 2000, and met on two occasions, in May and November 2000. On both occasions it heard presentations from firms with exposures to HLIs. The HLIWG also undertook a survey during the summer of 2000. This survey, conducted through nat ional supervisors, explored a number of topics, including: the nature of institutions' involvement with HLIs, management reporting and governance structure, information gathering, due diligence and credit analysis, exposure measurement, credit terms and limit setting, and collateral, early termination and documentation issues.
In its previous work on HLIs the Basel Committee outlined the following characteristics of such institutions: (i) they are subject to very little or no direct regulatory oversight. In the case of HLIs, this limited regulatory oversight results from such entities being structured as limited partnerships, investors being either institutions or sophisticated high net worth individuals and the securities issued taking the form of private placements. Moreover, a significant proportion of HLIs operate through offshore financial centres. (ii) HLIs are generally subject to very limited disclosure requirements, compared with regulated financial institutions and/or publicly traded companies, and are not subject to rating by credit-rating agencies. (iii) such institutions often take on significant leverage, where leverage is the ratio between risk, expressed in some common denominator, and capital. IOSCO, for the purposes of its report used a similar classification. It was recognised at the time of those reports tha t `highly leveraged institution' was not an ideal characterisation of all of the unregulated counterparties with which they were concerned. This remains the case but the term HLI has been retained in this report for continuity.
Mr Stefan Walter is Vice President, Market Risk Department, Federal Reserve Bank of New York.
Mr Paul Wright is Head of Department, Complex Groups, UK Financial Services Authority.
1 Banks' Interactions with Highly Leveraged Institutions, Basel Committee on Banking Supervision,January 1999.
2 Sound Practices for Banks' Interactions with Highly Leveraged Institutions, Basel Committee on Banking Supervision,January 1999.
3 Hedge Funds and Other Highly Leveraged Institutions, report by the Technical Committee of IOSCO, November 1999.
4 Banks' Interactions with Highly Leveraged Institutions: Implementation of the Basel Committee's Sound Practices Paper, Basel Committee on Banking Supervision,January 2000.