Banks' Interactions with Highly Leveraged Institutions: Implementation of the Basel Committee's Sound Practices Paper

Preface

In January 1999, the Basel Committee issued a report on Banks' Interactions with Highly Leveraged Institutions (HLIs) which analysed the quality of banks' risk management practices with regard to HLIs and discussed the related supervisory and regulatory issues. With respect to the latter, the report described different approaches which included indirect supervisory approaches, enhanced transparency and various direct approaches. While the broader policy issues are currently being addressed by various international groupings, the Committee, through its Working Group on Highly Leveraged Institutions, has focused on monitoring the implementation of the Sound Practices paper which it issued in conjunction with its analytical report.

The various sound practices recommended by the Committee were prompted by the experience of weaknesses in banks' risk management practices with respect to HLIs such as hedge funds, as witnessed, in particular, during the near-collapse of Long-Term Capital Management. A year after the publication of its original analysis and recommendations the Committee is providing an assessment of the response to its recommendations. This is important because HLIs can be expected to continue to expand their activities and to remain important players in the financial markets.

This anniversary review is based on the results of an informal survey carried out by banking supervisors in the G10 countries during 1999. The supervisors aimed to establish how banks in their jurisdiction have taken steps to improve the management of their involvement with HLIs. The survey recorded only a snapshot of the response by banks to the Committee's recommendations and as a result this follow-up report should be seen as a preliminary assessment of the progress made so far. This review also incorporates the Committee's assessment of the responses which have been formulated by various industry groups to the Committee's analysis and recommendations. These responses accepted and confirmed, by and large, the Committee's findings and proposals.

Over the period covered by the survey, banks appear to have considerably reduced their exposures to HLIs, although it should be pointed out that the number of banks having sizeable involvement with such institutions varies significantly from country to country. The decline in exposures may reflect a direct response to the increased uncertainty in the aftermath of the LTCM-incident. However, it is also important to evaluate banks' behaviour in the longer run, through improvements in their risk management practices vis-à-vis HLIs.

Overall, the Committee recognises that progress has been made in this field since the release of its report in early 1999. The Committee notes the steps that have been taken by bank supervisors and individual banks in addressing the concerns that were identified in its report and in implementing its proposed sound practices. Varying degrees of progress have been made with respect to banks' awareness of the potential risks and weaknesses in dealing with HLIs, due diligence in their credit policies for such institutions, collateral management arrangements when dealing with HLIs, and risk measurement practices. These improvements by banks play a critical role in the reduction of the potential risks posed to the financial system by the activities of HLIs.

Whereas a general consensus has emerged regarding the need for banks to improve the management of their counterparty credit exposures vis-à-vis HLIs, the development and implementation of enhanced risk measurement and management techniques has proven to be more difficult in some cases. This report therefore identifies a number of areas that require sustained attention.

Whatever the level of banks' direct exposures to HLIs, as pointed out in the Committee's report on HLIs, all banks and other market participants are likely to be affected by the second or third order effects that may result from a default of a large HLI. In addition, many of the issues identified in the Committee's report extend beyond the HLI sector and apply to the risk management of trading counterparties more generally. While the report focuses on progress with respect to HLI counterparties, its content should be seen in the light of possible future problems with all kinds of counterparties. The findings and follow-up recommendations of this report should therefore be of interest to a wide number of countries and organisations.