Banks feel chill of exposure from Fed’s SCCL

Basel’s large exposures framework is a central plank of regulatory efforts to prevent concentration of risk between big banking organisations and their counterparties. The objective is to ensure financial institutions extend a safe level of credit to a single counterparty.

That raises a question: how can authorities put a number on safe?

The US Federal Reserve has come up with two numbers: 15% and 25%. In the US, large banks must not take exposure to any one entity that adds up to more than 25% of the bank’s capital. The limit tightens to 15% for exposure to another systemically important entity.

The regulation, known as the single counterparty credit limits (SCCL) rule, is set to apply to the largest US and foreign banks from January 1, 2020 – although the Fed has just opened a consultation on whether to extend this deadline by another 18 months.

Across the industry, the rules will affect how financial institutions make credit decisions and allocate exposures between business units. To comply with the regulation, financial institutions should be prepared to manage the exposure calculation of complex instruments and to monitor limits beyond simple regulatory reporting.

The rule has some connection points with other requirements, such as Basel risk-based capital, legal lending limits from the Office of the Comptroller of the Currency, internal risk limits and monitoring frameworks.

On report

SCCL requires financial institutions to file quarterly reports known as FR 2590, and monitor compliance with the limits on a daily basis. The reports must contain gross and net credit exposure to each of the institution’s top 50 counterparties calculated from data at product and instrument level. Chief financial officers are responsible for certifying the data integrity of each report. The FR 2590 is confidential and will not be made available to the public.

SCCL is not the first regulation of its kind. In fact, there are other data collection requirements for credit exposure at the counterparty level. The Financial Stability Board requires systemically important banks to gather consolidated data for their largest counterparties, and exposures to different sectors and markets. The data is uploaded to an international data hub that pools the information and shares the data with national supervisory authorities. However, it’s not clear how the FR 2590 will impact the FSB data collection more broadly for the US systemic banks.

Even for banks with sophisticated credit risk management frameworks, the SCCL is no easy task. The complex reporting and monitoring elements bring significant interpretative and implementation challenges. Institutions will need to carefully analyse the detail of the rule, the products it applies to, and the bank’s relationship with counterparties.

In order to calculate aggregated net credit exposure, banks must consider direct and indirect exposures to counterparties across various products and credit risk mitigants. The existing Basel III framework and calculations might provide a solid base for SCCL, especially for over-the-counter derivatives and securities financing transactions. There are some differences between the two frameworks, though. For example, the impact of the credit conversion factor on the off-balance sheet portfolio, and collateral eligibility criteria.

To calculate counterparty exposures, risk shifting should be used. Here, risk is transferred to another counterparty: for example, a bank, corporate or security issuer. To accurately assess the transfer of risk, any transaction that has one or more credit mitigants – collateral, guarantees, credit derivatives, hedges, etc – should be carefully checked to determine whether the mitigants meet SCCL eligibility. Equity securities and convertible bonds that are publicly traded are an example of eligible collateral for SCCL that can be used to reduce exposure.

For overcollateralised transactions, or netting sets with multiple issuers, the current SCCL rule doesn’t provide guidance on which part of the collateral can be used for transfer of risk. Financial institutions must examine issues such as legally binding agreements, types of guarantees, and credit derivatives contracts. In the case of overcollateralised transactions or netting sets, institutions may use a weighted average approach or conservative approach of assigning lower haircuts to collateral.

Command and control

Economic interdependence and control relationships are the most dynamic and complex parts of SCCL. Economic interdependence describes how default or financial distress in one counterparty causes default or financial distress in a related counterparty. Control relationships are the ownership of voting rights in another counterparty.

The information required for SCCL is global in nature and at multiple levels of counterparty and country. Some institutions may not have the knowledge or the authority to reveal such information. Also, this information is not available in the public domain and hardly any vendors have all the information required for SCCL implementation.

Institutions can combat this by enhancing their existing data sources for counterparties to capture these details. They can also set up regular updates reflecting ownership and economic interdependence links in trades with other counterparties.

The daily calculation of credit exposure and its comparison with regulatory limits requires daily data availability, sophisticated credit risk calculations and highly automated processes with minimal room for manual adjustments. This may entail a huge ramp-up of data infrastructure, calculations and technology for banks.

Banks may consider building calculations for certain SCCL components on a daily basis and for other components where daily data is unavailable. Also, certain institutions can meet daily limits by adopting policies for compliance (subject to regulatory approval), which may include regular impact assessments, and setting up early warning indicators and hard thresholds. To demonstrate to regulators that counterparty exposures are well below limits, banks may also introduce escalation processes of breaches to internal thresholds and remediation plans for non-compliance (eg, business restrictions in case of limit violations).

Certain elements of SCCL are still pending: the final version of the FR 2590 reporting form, the CUSO exemption and certification process for foreign banks, US presidential reform plans for government-sponsored enterprises (ie, the loss of Fannie and Freddie’s conservatorship status), etc. These open regulatory items pose implementation challenges, and any material deviations from the proposal would increase operational risk and may hamper the timely delivery of SCCL.

Deependra Kushwaha heads US Basel III reporting at a global bank. The views and opinions expressed in this article are his own, and do not represent the opinions of any affiliated entity.