By Steven K. Beckner
(MNI) – Federal financial regulators issued final guidelines on
Friday on how banks should monitor and manage their credit and funding
risk exposures to other financial institutions.
The Federal Reserve, the Federal Deposit Insurance Corporation and
the Office of the Comptroller of the Currency issued guidelines on
“Correspondent Concentration Risks” (CCR) directing banks to be aware of
and to control their risks vis-a-vis other firms and their affiliates.
In a joint statement of “guidance,” the Fed, the FDIC and the OCC
outlined their “expectations for financial institutions to identify,
monitor, and manage credit and funding concentrations to other
institutions on a standalone and organization-wide basis, and to take
into account exposures to the correspondents’ affiliates, as part of
their prudent risk management practices.”
“Institutions also should be aware of their affiliates’ exposures
to correspondents as well as the correspondents’ subsidiaries and
affiliates,” the statement continued.
“In addition, the CCR Guidance addresses the Agencies’ expectations
for financial institutions to perform appropriate due diligence on all
credit exposures to and funding transactions with other financial
institutions,” the agencies added.
The guidance, which Fed, FDIC and OCC examiners will enforce
through their supervisory exercises, applies to all banks and their
subsidiaries, bank holding companies and their nonbank subsidiaries,
savings associations and their subsidiaries, and savings and loan
holding companies and their subsidiaries.
The guidelines are obviously intended to address the kinds of
problems that arose during the financial crisis, when a liquidity crisis
among major financial institutions with close ties to other firms led in
some cases to insolvency and failure.
The most notable example is what happened in September 2008, when
heavy losses on its subprime mortgage portfolio triggered bankruptcy at
Lehman Brothers. Lehman’s commercial paper and credit default swaps
became worthless, setting off a series of dramatic aftershocks on Wall
Street and throughout the financial system that intensified the
financial crisis and recession.
The Fed, FDIC and OCC define “credit” or “asset risk” as “the
potential that an obligation will not be paid in a timely manner or in
full” in a supporting document.
“Credit concentration risk arises whenever an institution advances
or commits a significant volume of funds to a correspondent, as the
advancing institution’s assets are at risk of loss if the correspondent
fails to repay,” it says.
The document says “funding” or “liability concentration risk”
“arises when an institution depends heavily on the liquidity provided by
one particular correspondent or a limited number of correspondents to
meet its funding needs.”
“Funding concentration risk can create an immediate threat to an
institution’s viability if the advancing correspondent suddenly reduces
the institution’s access to liquid funds,” it adds.
“For example, a correspondent might abruptly limit the availability
of liquid funding sources as part of a prudent program for limiting
credit exposure to one institution or organization or as required by
regulation when the financial condition of the institution declines
rapidly,” the agencies say, adding that they “realize some
concentrations arise from the need to meet certain business needs or
purposes, such as maintaining large due from balances with a
correspondent to facilitate account clearing activities.”
“However, correspondent concentrations represent a lack of
diversification that management should consider when formulating
strategic plans and internal risk limits,” they caution.
The agencies regard credit exposures arising from direct and
indirect obligations in an amount “equal to or greater than 25% of total
capital” as being “concentrations.”
“Depending on its size and characteristics, a concentration of
credit for a financial institution may represent a funding exposure to
the correspondent,” says the joint statement.
The agencies have not established a funding concentration
threshold, but the document notes that “the Agencies have seen instances
where funding exposures of 5% of an institution’s total liabilities have
posed an elevated risk to the recipient, particularly when aggregated
with other similar sized funding concentrations.”
The document cites the following example of how interbank
correspondent risks can become concentrated:
“Respondent Institution (RI) has $400 million in total assets and
is well capitalized with $40 million (10 percent) of total capital. RI
maintains $10 million in its due from account held at Correspondent Bank
(CB) and sells $20 million in unsecured overnight Federal funds to CB.
“These relationships collectively result in RI having an aggregate
risk exposure of 75 percent of its total capital to CB. CB, which has $2
billion in total assets, $1.8 billion in total liabilities, and is well
capitalized with $200 million (10 percent) total capital, has a total of
20 respondent banks (RB) with the same credit exposures to CB as RI has
to CB. The 20 RBs $600 million aggregate relationship represents
one-third (33 percent) of CB’s total liabilities.”
The agencies warn that “these relationships create significant
funding risk for CB if a few of the RBs withdraw their funds in close
proximity of each other. ”
“These relationships also could threaten the viability of the 20
RBs,” they go on to say. “The loss of all or a significant portion of
the RBs’ due from balances and the unsecured Federal funds sold to CB
could deplete a significant portion of their capital bases, resulting in
multiple institution failures.”
The respondent banks’ “viability also could be jeopardized if CB,
in turn, had sold a significant portion of the Federal funds from the
RBs to another financial institution that abruptly fails,” they warn.
“In addition, the financial institutions that rely on CB for account
clearing services may find it difficult to quickly transfer processing
services to another provider.”
The final guidelines, propounded after a period of public comment,
take effect immediately upon their publication in The Federal Register.
** Market News International **
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