A banking organization may provide financial support to another entity that is under financial stress even though there may be no legal, regulatory or contractual obligation to do so. This so-called “step-in risk” is the subject of new international guidelines issued in October by the Basel Committee on Banking Supervision of the Bank for International Settlements (Basel Committee). (Basel Committee on Banking Supervision, “Guidelines: Identification and management of step-in risk,” October 2017.) The Basel Committee is a group of international banking supervisors which set international standards for banking organizations such as capital, liquidity and the like, which then are adopted by individual jurisdictions.

This month's column will review these new guidelines, which the Basel Committee expects jurisdictions to adopt by 2020. These guidelines are part of a continuing effort to strengthen oversight and regulation of the so-called “shadow banking system,” which is defined by the Financial Stability Board as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system.” (The Financial Stability Board was established by the G-20 group of nations to promote financial stability. See www.fsb.org.)

The key elements banking organizations need to remember about these guidelines are that they are to be incorporated into their risk management function, and that they must have policies and procedures in place to, among other things: (1) regularly review and identify entities that could be candidates for step-in, (2) analyze each entity to determine those where the step-in risk might be significant and material, (3) determine how such risk might be managed or mitigated, and (4) report on such risks on a regular basis to their regulators.

As defined in the guidelines, “step-in risk” is “the risk that a bank decides to provide financial support to an unconsolidated entity that is facing stress, in the absence of, or in excess of, any contractual obligations to provide such support.” Why a need to step-in? As the Basel Committee notes, it may be to avoid the reputational risk to the banking organization if it does not provide support to the entity in question.

Identifying Entities

The first step is for the banking organization to identify which entities should be scrutinized for step-in risk and the banking organization's relationship to them. In the first instance, these would be entities that are not consolidated with the banking organization for regulatory purposes. The guidelines provide the example of a joint venture into which the banking organization has entered—it might be consolidated into the banking organization's financial statements for accounting purposes, but not considered consolidated for regulatory purposes. Thus, the joint venture would be subject to consideration under the guidelines.

The guidelines deliberately do not provide a comprehensive definition of entities that should be subject to scrutiny under the guidelines. Rather, the guidelines focus on the situations that can give rise to the risk, citing securitization vehicles and investment funds at a minimum to be reviewed.

The banking organization should categorize its relationship with each of the entities to be reviewed:

• Does it serve as a sponsor of the entity such as managing or advising the entity?

• Does it invest in the entity's debt or equity (aside from loans to operating entities or investments related to market-making)?

• Does it have some other relationship (whether or not contractual) to the entity that will expose it to risks (or receive returns) resulting from the entity's assets or related to its performance?

The guidelines provide examples of various securitization vehicles and investment funds, and other entities to be considered for scrutiny under the guidelines.

Scrutinizing the Risk

After the pool of potential entities to be evaluated for step-in risk has been identified, there may be some that can be eliminated from that analysis, such as where a particular jurisdiction's law or regulation explicitly prohibits a banking organization from stepping in to provide financial support to certain types of entities. Under the guidelines, such a law or regulation must be clearly enforceable, of general application and explicitly prohibit the banking organization from providing the support; mere contract law or industry standards are insufficient.

After adjusting for those entities that can be excluded from scrutiny, the guidelines then set out certain “indicators” against which to evaluate the entity to determine whether it poses a significant step-in risk. The guidelines provide that the banking organization should focus on the “purpose and design of the entity,” including the entity's activities and who directs and makes decisions about them, the banking organization's relationship with the entity, and who receives the entity's returns or is exposed to the entity's risks.

While the list of indicators is not meant to be exhaustive, it covers a broad range of factors to consider:

• Nature and degree of the banking organization's sponsorship of the entity such as guarantees or other credit enhancements

• The degree of influence the banking organization has over the entity that would give it a greater incentive to step in if the entity suffered financial distress

• Whether the banking organization is perceived as providing an implicit guarantee of support, such as a rate of return on investment in the entity

• The extent to which the entity may be highly leveraged relative to the risks normally associated with its assets

• The potential adverse impact on the banking organization's liquidity if it must provide financial support to an entity that might have limited capacity on its own to access liquidity when necessary

• An analysis of the entity's transparency and requirements to provide detailed financial disclosures so an investor can adequately evaluate the risks of such an investment, which could include a discussion regarding the banking organization's ability to provide financial support to the entity if necessary

• Whether there are accounting disclosure requirements that would provide meaningful information to evaluate the nature and risks of a banking organization's involvement with the entity

• Do the risk exposures of the entity match the risk appetite of an investor in the entity (who may not realize that there is a greater risk than he or she may believe is associated with that entity's activities)

• An analysis of whether there is reputational risk associated with the banking organization when the entity shares customers or branding with the banking organization, which in turn could strengthen a presumption or perception by investors in that entity that the banking organization would provide financial support to the entity if necessary

• Any past history of support provided by the banking organization to the entity

• The extent to which there are any adverse regulatory restrictions which might affect the ability of the banking organization to provide support, such as higher capital or collateralization requirements

Managing or Mitigating Such Risk

After analyzing each entity against each of the indicators and the banking organization has identified those entities that potentially could pose a significant and material step-in risk, the next step is to determine how the banking organization can manage or even mitigate such risk. These steps would be in addition to any risk-based capital requirements that might be applicable in a particular jurisdiction.

The guidelines note that if the banking organization already has substantial contractual obligations to provide support to an entity and there is a significant risk that the banking organization would go beyond those obligations if necessary to support the entity, regulatory consolidation might be the most appropriate solution. That way, the banking organization would apply its risk-based capital requirements to its relationship with the entity. This is especially useful when the entity's activities would be those already included in the capital requirements (such as extensions of credit). However, the guidelines note that banking organizations should use this approach on a limited basis and not when such consolidation would artificially improve the capital or liquidity position of the banking organization and the entity's assets and resources could not be accessed by the banking organization.

The guidelines offer additional examples of how to manage and mitigate potential significant and material step-in risk, including the following:

• Using a conversion factor: the banking organization could treat the entity as an off-balance sheet asset and apply a conversion factor in the way that the risk-based capital requirements would treat such an off-balance sheet asset (such as certain loan commitments)

• Liquidity Requirements: the banking organization could apply its applicable liquidity requirements to account for the step-in risk as non-contractual funding obligations

• Stress testing: the banking organization could include the entity in its stress tests to help it determine whether it needs to maintain additional capital or liquidity to mitigate the effect of any step-in by the banking organization

• Provisioning: the banking organization could estimate potential cash flows that could result from a step-in, assess the expected “fire sale” value of the entity's assets and set aside additional capital accordingly

• Capital charges after the fact: the banking organization's regulator could impose a capital charge after the banking organization steps-in with respect to a particular entity that could be the same or considerably higher than if it were already on the balance sheet; this could act as an incentive for the banking organization to take proactive steps prior to a need to step-in

• Treat the entity as a large exposure for purposes of setting internal limits: some jurisdictions already require this management/mitigation method whereby the banking organization applies an internal limit to its exposure to the entity whether through an analysis of its contractual obligation with the entity, and/or estimation of the banking organization' step-in risk with respect to a particular entity

• Required disclosure: the banking organization's regulator could require public disclosure of a banking organization's relationship with the entities that pose step-in risk and how the banking organization manages the risks of each relationship

Even after applying any of these mitigation measures, banking organizations should determine whether there still may be some residual step-in risk remaining with respect to a particular entity.

Reporting to the Regulator

The last major section of the guidelines discusses a banking organization's reporting the results of its self-assessment of its step-in risk to its regulators, preferably on a annual basis, whether as part of a current regulatory reporting process or a stand-alone requirement. The guidelines provide template reports for individual jurisdictions to consider adopting.

It would be expected that a banking organization's risk management policies and procedures regarding step-in risk would be reviewed during its regulator's periodic examination or assessment of the banking organization. Regulators of internationally active banking organizations should plan to share information with their counterparts in other jurisdictions regarding their assessment of the particular banking organization's step-in risk management policies and procedures.

Conclusion

Banking organizations collectively may sigh when their jurisdictions impose yet another set of policies and procedures and reporting requirements on them. This may be the case even though many of them already may have included some version of this analysis in their risk management policies and procedures. These guidelines are another attempt to address some of the flaws in the international banking system that were manifest in the last financial crisis and can be seen as a natural progression from the risk-based capital and liquidity standards developed in the last several years. While it is difficult for any banking organization to see into the future to anticipate problems, heightened step-in risk can sneak up on a banking organization if it does not stay on top of all its relationships from a risk management perspective. These guideline aim to assist those banking organizations in staying up-to-date in their analysis of those risks.

Kathleen A. Scott is senior counsel in the New York office of Norton Rose Fulbright.