The Basel Committee (the “Committee”) has recently published a second consultation on guidelines for identification and management of step-in risk, which follows on from a previous consultation issued in December 2015. The previous consultation set out a framework for banks to deal with “step-in risks” (defined as a risk that a bank decides to provide through financial support to an unconsolidated entity that is facing stress, in the absence of, any contractual obligations to provide such support). The Committee emphasises that the framework is not intended to provide solutions for specific examples of step-in risk, but to allow banks to choose the appropriate response once a step-in risk has been identified. The framework should be used by supervisors to check and challenge a bank’s response, if necessary.
WHY GUIDANCE IS NEEDED
The Committee believe that although the previous initiatives introduced i.e. in relation to capital and liquidity requirements, have reduced the likelihood of banks having to step-in, the risk is still there and they believe that a framework which provides a tailored approach to step-in is the most appropriate response. Whilst the framework is largely confirmed, the Committee are still welcoming comments from stakeholders as to the final framework.
ACTIONS FOR BANKS
As mentioned above, the Committee believes that a tailored approach to step-in is the best course of action and so it has devised a structured framework which sets out clearly the steps banks need to take to assess the likelihood of step-in risk, namely:
- define all entities to be evaluated for potential step-in risk, taking into account their relationship with the bank;
- identify entities that are immaterial or subject to collective rebuttals and exclude them from the initial set of entities to be evaluated;
- assess all remaining entities against the step-in risk indicators including potential migrants;
- use the estimate method deemed appropriate to estimate the potential impact on liquidity and capital positions – measurement of the risk – and determine the appropriate internal risk management action, for entities where step-in risk is defined; and
- report its self-assessment of step-in risk to its supervisor, according to the reporting templates.
Banks need to consider any unconsolidated entities, i.e. those defined as not within the scope of regulatory consolidation, as a possible risk for step-in. As a minimum, banks should assess relationships with securitisation vehicles and investment funds. They should exclude the assessment of any entities where stepping in to support them would not be material to the bank’s liquidity and/or capital position.
IDENTIFICATION OF STEP IN RISK
The first step of the framework requires that banks should evaluate the entities that it believes could be a step-in risk, therefore the Committee has identified a number of indicators that banks can use to determine if a particular entity carries such a risk:
The indicators are as follows:
- the nature and degree of sponsorship, ie. a bank provides full sponsor support via a guarantee;
- the degree of influence, ie. a greater degree of influence may indicate a greater incentive to step-in in times of trouble;
- implicit support, ie. a bank is providing implicit guarantee to investors;
- structured entities/variable interest entities and highly leveraged entities;
- liquidity stress/first-mover incentive, ie. entities with a limited capacity to access liquidity when facing an unanticipated increase in redemption requests;
- risk transparency for investors;
- accounting disclosures;
- investor risk alignment, ie. funds that mix different term and/or wealth expectations into a single fund type;
- reputational risk from branding and cross-selling;
- historical dependence; and
- regulatory restrictions and mitigations.
MEASURES FOR DEALING WITH ENTITIES AT RISK OF STEP-IN
Once a bank has identified a significant step-in risk to an entity using the indicators above, it can apply a range of risk measurement and management measures to deal with that entity. The Committee has identified both comprehensive measures and also targeted measures, i.e. liquidity requirements and stress testing that can be used supplement the comprehensive measures. Comprehensive measures include:
- inclusion in the regulatory scope of consolidation – this may be the most appropriate measure, particularly where the entity’s balance sheet are amenable to banking regulations; and
- conversion approach – banks should use this approach when it is not appropriate for them to consolidate at risk entities. A conversion factor would be applied to the entity’s exposures and will be used to determine a response in terms of increased capital requirements. This is a very flexible approach and can be adapted depending on whether the step-in risks are deemed high or low.
As mentioned in step 5 of the framework, banks, in accordance with their policies and procedures, must regularly identify all entities giving rise to step-in risk. For all such entities, banks should estimate the potential impact on their liquidity and capital that step-in risk could entail. Banks must regularly report the results of their self-assessment of step-in risk to their supervisor, however, regardless of how often banks are required to report their results, they should continue to regularly assess step-in risk.
The Committee welcomes responses from firms on their document by 15 May 2017. To submit comments, please go to:
To access the consultative document in full, please click here.
For more information, and any guidance or advice on step-in risk, Cleveland & Co, your External in-house counsel, are here to help.