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May 1, 2014

Basel Large Exposures Framework

Basel Committee Publishes Standards for the Supervisory Framework for Measuring and Controlling Large Exposures

SUMMARY

The Basel Committee on Banking Supervision (the “Basel Committee”) recently published final standards

for the supervisory framework for measuring and controlling large exposures (“LE Framework”)1 of

internationally active banking organizations. The LE Framework, like loan-to-one-borrower limits for

banks, is used to identify, measure, and limit, as a percentage of an institution’s capital, exposures to a

counterparty. It also is designed in part to address interconnectedness among systemically important

financial institutions.2 The LE Framework is similar to the single counterparty credit limit (“SCCL”) under

Section 165(e) of the Dodd-Frank Act, which requires the Board of Governors of the Federal Reserve

System (“Federal Reserve”) to adopt rules imposing a limit on exposures to a single counterparty by

banking organizations with $50 billion or more in consolidated assets and nonbank financial institutions

designated by the Financial Stability Oversight Council (“covered companies”).3 The Federal Reserve

proposed rules to implement the SCCL (“Proposed SCCL Rule”) in December 20114 and December

20125 along with other enhanced prudential standards for covered companies, but the SCCL was not

included with the final enhanced prudential standards recently issued by the Federal Reserve.6 The

Federal Reserve has indicated that it is coordinating the final SCCL with the LE Framework.7 The annex

to this memorandum provides a detailed comparison of the Proposed SCCL Rule and the LE Framework.

The LE Framework is to be fully implemented by January 1, 2019, but reporting may be required by

national supervisors earlier.8 By comparison, Section 165(e) of the Dodd-Frank Act contemplates that the

SCCL requirement will be effective by July 21, 2015.9 During an observation period that runs until 2016,

the Basel Committee will review whether exposures to qualifying central counterparties (“QCCPs”), which

are currently exempt under the LE Framework to the extent they relate to clearing activity, should be

-2- Basel Large Exposures Framework May 1, 2014

subject to the limit and the potential impact that subjecting certain interbank exposures to the LE

Framework could have on the conduct of monetary policy.10

The Basel Committee specifically encourages national supervisors to consider whether more stringent

requirements should be applied in a particular jurisdiction, particularly with respect to domestic

systemically important banks (“D-SIBs”).11

KEY CONSIDERATIONS

In general, the LE Framework imposes a limit of 25% of the effective amount of Tier 1 capital12

on

exposures to a counterparty, with a lower 15% limit for exposures between G-SIBs.13

The LE Framework

requires a banking organization to report to its supervisor when its exposure to a counterparty reaches

10%.14

Certain of the LE Framework provisions, many of which are modifications to the Basel Committee’s

proposed large exposures framework (“Basel LE Proposal”),15

should help make the LE Framework more

workable. These include:

An exemption from the limit for all exposures to sovereigns, their central banks, and public sector entities treated as sovereigns for purposes of risk-based capital requirements. Although exempt from the limit, these exposures are nonetheless subject to reporting requirements.

16

An exemption for exposures to QCCPs for clearing activity, subject to review during the observation period.

17

The use of the Basel Committee’s recently finalized standardized approach for measuring counterparty credit risk (“SA-CCR”), such as for OTC derivative transactions, rather than the current exposure method.

18

Application of a 15% limit on exposures between G-SIBs rather than the alternative 10% limit included in the Basel LE Proposal.

19

A limited scaling back of the “risk-shifting” requirement for purchased protection. In general, when a banking organization purchases protection in the form, for example, of a credit derivative or guarantee, it must shift the full amount of the exposure (up to the amount of protection purchased) from the issuer of the hedged exposure to the protection provider. Risk shifting of the full amount of protection purchased will not be required, however, when CDS protection is purchased for the trading book if neither the CDS provider nor the referenced entity is a financial entity. Instead, the exposure to the protection provider will be measured under SA-CCR. The definition of “financial entity” is expansive, however, and includes many common CDS providers, which may limit the usefulness of this exception.

20

The treatment of securities financing transactions (“SFTs”) under the LE Framework has not been

finalized. Until the Basel Committee completes its review of a comprehensive approach for measuring

SFT exposures, the exposure is to be calculated using the same method a banking organization uses to

calculate its risk-based capital requirements for SFTs.21


Other provisions in the LE Framework remain restrictive and, in some cases, are likely to pose

implementation difficulties. These include:

The use of Tier 1 capital as the denominator of the ratio,22

a more restrictive denominator than, for example, in the Proposed SCCL Rule,

23 which would use total regulatory capital plus excess loan

loss reserves (although better than the alternative included in the Basel LE Proposal of using Common Equity Tier 1).

24

Application of the LE Framework at each level of the consolidated banking organization.25

The Proposed SCCL Rule, by contrast, applies only at the consolidated level. In the United States and other jurisdictions, a separate lending limit already applies at the depository institution level.

26

The requirement that “connected counterparties” be aggregated when calculating compliance with the limit. The standards for determining “connected counterparties” are the presence of a “control relationship” or “economic interdependence,” which are subjective standards that will likely require fact-intensive reviews of counterparty interconnectedness.

27

A detailed “look-through approach” that requires a banking organization in many circumstances to determine its exposure to the underlying assets of investment vehicles and other structures.

28

* * *

Copyright © Sullivan & Cromwell LLP 2014


ENDNOTES

1 Basel Committee on Banking Supervision, Standards: Supervisory framework for measuring and

controlling large exposures, dated April 2014.

2 See Basel Committee on Banking Supervision, Core Principles for Effective Banking Supervision,

dated September 2012 (Principle 19).

3 Dodd-Frank Wall Street Reform and Consumer Protection Act § 165(e)(7), 12 U.S.C. §§

5365(a)(1), 5365(e)(2) (2010).

4 Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies,

77 Fed. Reg. 594 (proposed Jan. 5, 2012) (to be codified at 12 C.F.R. pt. 252)

5 Enhanced Prudential Standards and Early Remediation Requirements for Foreign Banking

Organizations and Foreign Nonbank Financial Companies, 77 Fed. Reg. 76628 (proposed December 28, 2012) (to be codified at 12 C.F.R. pt. 252).

6 Enhanced Prudential Standards for Bank Holding Companies and Foreign Banking

Organizations, 79 Fed. Reg. 17240, 17243 (Mar. 27, 2014); See our Client Memorandum, “Federal Reserve Approves Final Rule Implementing Certain Provisions of Section 165 of the Dodd-Frank Act Increasing Supervision and Regulation of Large U.S. Bank Holding Companies and Foreign Banking Organizations,” dated February 24, 2014, available at http://sullcrom.com/enhanced-prudential-standards-for-large-us-bank-holding-companies-and-foreign-banking-organizations.

7 77 Fed. Reg. at 76654; 79 Fed. Reg. at 17243.

8 LE Framework at ¶¶ 93, 94.

9 See 12 U.S.C. § 5365(e)(7)(A) (provision not effective until 3 years after date of enactment, July

21, 2010); 12 U.S.C. § 5365(e)(7)(B) (Federal Reserve may extend for an additional 2 years).


11 LE Framework at ¶ 91.

12 LE Framework at ¶ 17; see Basel Committee on Banking Supervision, Basel III: A global

regulatory framework for more resilient banks and banking systems, dated December 2010, revised June 2011, ¶¶ 52-56, for a description of qualifying Tier 1 capital.



15 Basel Committee on Banking Supervision, Consultative Document: Supervisory framework for

measuring and controlling large exposures, dated March 2013.








23 77 Fed. Reg. at 613.

24 Basel LE Proposal at 7.

http://sullcrom.com/enhanced-prudential-standards-for-large-us-bank-holding-companies-and-foreign-banking-organizations

http://sullcrom.com/enhanced-prudential-standards-for-large-us-bank-holding-companies-and-foreign-banking-organizations


ENDNOTES (CONTINUED)

25

LE Framework at ¶ 10.

26 See 77 Fed. Reg. at 613.

27 LE Framework at ¶¶ 19-28.

28 LE Framework at ¶¶ 72-83.


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Annex – Comparison of Proposed Single Counterparty Credit Limit Rule and Basel Final Large Exposure Framework

A. General Provisions

Provision Proposed SCCL Rules Basel Final LE Framework

Timing of implementation

Section 165(e) provides that the Federal Reserve may not extend the 3-year transition period (which ran from July 21, 2010, to July 21, 2013) beyond July 21, 2015.

By January 1, 2019, although national supervisors may require reporting in advance of the compliance date.

Companies subject to exposure limit

Bank holding companies with $50 billion or more in total consolidated assets and nonbank financial companies designated by the FSOC (“covered companies”).

Provisions may be tailored to the specific circumstances of designated nonbank financial companies.

Internationally active banking organizations.

Level at which limit applies

At consolidated level only (but a lending limit and investment securities limit already apply at the bank level).

The limit applies to exposures at the parent company and any subsidiaries the parent “controls.” See “Scope of counterparty” below for the definition of control.

At every tier that risk-based capital requirements are required to be applied (i.e., at every tier within a banking group).

Denominator Total regulatory capital plus excess loan loss reserves (“capital stock and surplus”).

Effective amount of Tier 1 capital fulfilling the criteria in Part 1 of the Basel III framework (“eligible capital”).

General limit 25% of capital stock and surplus. Reporting to the supervisor is required at 10% of bank’s eligible capital (before and after application of credit risk mitigation techniques).

Limit imposed at 25% of eligible capital.

G-SIB limit 10% of capital stock and surplus. 15% of eligible capital.

Jurisdictions are encouraged to consider whether a stricter limit for D-SIBs may be appropriate.



Compliance/ breaches

A covered company must be in compliance on a daily basis at the end of each business day and submit a monthly report demonstrating daily compliance.

Generally 90-day cure period solely for breaches that arise from the circumstances below during which time the covered company may not incur additional exposure to the counterparty:

decrease in covered company’s capital stock and surplus;

merger of the covered company with another covered company;

merger of two unaffiliated counterparties; or

other circumstances as determined by the Federal Reserve.

Breaches “must remain the exception” and be reported to the supervisor immediately and rapidly fixed.

Scope of counterparty

“Counterparty” includes all controlled subsidiaries. A company “controls” another company if it:

owns, controls or holds with power to vote 25% or more of a class of a company’s voting stock;

owns or controls 25% or more of a company’s total equity; or

consolidates for accounting purposes.

Counterparty includes all connected counterparties, which is determined based on a “control relationship” or “economic interdependence”:

General:

o When a “control relationship” is established, a bank may still demonstrate to its supervisor in exceptional cases that the entities should not be treated as connected.

o Even when the prescribed criteria are satisfied, a bank can rebut the presumption of “economic interdependence.” In addition, analysis of economic interdependence only needs to be undertaken where the sum of all exposures to a counterparty exceeds 5% of the eligible capital base.



Control relationship:

o More than 50% of the vote is automatic non-rebuttable control.

o Indicia of control to be considered:

voting agreements;

significant influence on the appointment or dismissal of an entity’s management or supervisory body; or

significant influence on senior management (e.g. consent rights over key decisions).

o Guidance on control from accounting standards.

Indicia of economic interdependence:

o 50% or more of an entity’s gross receipts or expenditures is derived from transactions with another entity;

o partial or full guarantee of an exposure and the exposure is so significant that the guarantor is likely to default if a claim occurs;

o significant part of an entity’s production/output is sold to another counterparty (and cannot be easily replaced by other customers);

o expected source of repayment is the same for two entities;

o financial problems at one entity would cause difficulties for another entity in terms of its ability to repay liabilities in a timely manner;

o insolvency or default of one counterparty is likely to be associated with the insolvency or default of another;



o entities that rely on the same source for the majority of their funding and in the event of the provider’s default, an alternative provider cannot be found.

Attribution rule A credit transaction (the transactions listed in the “Valuation Provisions” chart below) with any person must be treated as a credit exposure to a counterparty to the extent the proceeds of the transaction are used for the benefit of, or transferred to, that counterparty.

Federal Reserve noted in preamble that the intent of the statutory attribution rule would be to catch evasions rather than expand the scope of the SCCL.

None.

Sovereign exposures

Exposures to the United States, including agencies and instrumentalities, but excluding States and their political subdivisions, such as municipalities, are exempt from coverage.

Fannie and Freddie are exempt while under conservatorship.

All exposures to sovereigns and their central banks are exempt from the limit, but are subject to the reporting requirement.

Public sector entities treated as sovereigns for purposes of risk-based capital requirements also are exempt.

Any portion of an exposure guaranteed by, or secured by financial instruments issued by, sovereigns are exempt to the extent they meet eligibility criteria for recognition of CRM.

Two entities controlled by a sovereign or economically dependent on a sovereign but otherwise not connected are not counted as a group of connected counterparties (see “Scope of Counterparty” above).

The exemption for sovereign exposures does not exempt a credit derivative hedge on the sovereign, and the exposure to the counterparty writing the credit derivative must still be included.

Intraday exposures

All intraday exposures exempt. Intraday interbank exposures are not subject to the LE framework, including that no reporting is required.



Interbank exposures

Not addressed. As noted above, intraday interbank exposures are not subject to the LE framework.

The LE Framework notes that supervisors may have to accept a breach of an interbank limit ex post in stressed circumstances to help ensure stability in the interbank market.

The Basel Committee will continue to review whether exemptions for other types of interbank exposures may be necessary to ensure there are no adverse consequences for the implementation of monetary policy. The observation period will be concluded by 2016.

CCP exposures No exemption for transactions with central counterparties (CCPs) (that is, they are treated as any other derivative transaction).

Guaranty fund contributions are also subject to limit.

Exposures to QCCPs related to clearing activities are exempted from the LE Framework during the observation period.

For all other CCPs, a bank must measure its exposure to include both clearing activities and other types of exposures not directly related to clearing services.

For clearing services, exposure values are as follow.

o Trade exposure is measured according to the type of transaction (e.g., SA-CCR for derivative exposures).

o Segregated initial margin has a value of 0.

o Non-segregated initial margin is the nominal amount of initial margin posted.

o Pre-funded default contributions is the nominal amount of the funded contribution.

o Unfunded default fund contributions have a value of 0.

o Equity stakes have a value of the nominal amount.



Covered bond exposures

Not addressed. Assigned an exposure value of 100% of the nominal value of the bank’s covered bond holding unless certain criteria are met, in which case the value may be reduced, subject to a 20% floor. To be assigned a lower value, a covered bond must meet certain conditions, including that the underlying assets are very low risk (such as sovereign exposures and mortgages with LTV ratios of 80%) and are over-collateralized by at least 10%.

Exposures to collective investment undertakings, securitization vehicles, and other structures

Proposed SCCL Rule includes a reservation of authority for the Federal Reserve to look through some SPVs either to the issuer of the underlying assets in the vehicle or to the sponsor. Alternatively, the Federal Reserve may require covered companies to look through to the underlying assets of an SPV if the SPV fails certain discrete concentration tests, such as having more than 20 underlying exposures.

The Federal Reserve posed the question whether money market mutual funds and certain other funds or vehicles that the covered company sponsors or advises should be included as part of the covered company for purposes of the SCCL.

Exposure is to the structure itself if the bank’s exposure to each underlying asset is less than 0.25% of eligible capital.

Otherwise, a detailed look-through approach is applied.

Finally, a bank must consider additional risk factors presented by third parties associated with these structures, such as originators, fund managers, liquidity providers, and credit-protection providers and generally treat as connected counterparties those structures that share a common risk factor.


B. Valuation Provisions

SCCL Exposure Proposed SCCL Rules LE Exposure Basel Final LE Framework

Exposures subject to SCCL

Each exposure identified below. Exposures subject to LE Framework

All exposures defined under the risk-based capital framework.

An exposure to a counterparty that is deducted from capital is not added to other exposures to that counterparty, unless the exposure carries a 1,250% risk-weight.

Loans Valued at the amount owed by the counterparty.

On balance sheet items/banking book

Accounting value of the exposure. (As an alternative, a bank may consider the exposure value gross of specific provisions and value adjustments.)

Committed credit lines

Valued at the face amount of credit line.

Unused portions of uncommitted credit lines or revolving credit facilities may be excluded in some circumstances.

Debt securities Held to maturity: Amortized purchase price.

Trading and available for sale: Valued at the greater of the amortized purchase price or market value.

Equity securities

Valued at the greater of the purchase price or market value.

Guarantees and letters of credit

Guarantees and letters of credit valued as the lesser of the face amount or the maximum potential loss to the covered company.

Traditional off-balance sheet items/banking book

Items are converted into credit exposure equivalents through the credit conversion factors used in the standardized approach, subject to a 10% floor.



OTC derivatives

If subject to a qualifying master netting agreement, then valued at an amount equal to the exposure at default, calculated according to the current exposure method (CEM).

If not subject to a qualifying master netting agreement, then valued at current exposure and an estimate of potential future exposure (notional multiplied by a conversion factor).

OTC derivatives and all other exposures that give rise to counterparty credit risk other than SFTs/ banking book or trading book

Valued at exposure at default measured according to the standardized approach for counterparty credit risk (SA-CCR).

Credit or equity derivative transactions in which covered company is the protection provider

Lesser of the face amount of the transaction or the maximum potential loss to the covered company on the transaction.

Credit derivative transactions in which covered company is the protection provider

See “Trading book sold credit protection” below.

Reverse repurchase agreement

Amount of cash transferred to the counterparty.

May apply netting if subject to bilateral netting agreement.

SFTs Banks should use the method currently used for calculating their risk-based capital requirements against SFTs until the Basel Committee undertakes a review of a comprehensive approach to be used to measure SFT exposures.

Securities borrowing

Amount of cash collateral plus the market value of securities collateral transferred to the counterparty.

May apply netting if subject to bilateral netting agreement.



Repurchase agreement

Market value of securities transferred + (market value of securities transferred x collateral haircut).

May apply netting if subject to a bilateral netting agreement.

Securities lending

Same as repurchase transactions.

Netting See specific transactions for netting.

Gross credit exposure to a counterparty for a credit transaction may be reduced by the face amount of a short sale of the counterparty’s debt or equity security.

See “Recognizing eligible protection” below for additional calculations to arrive at net credit exposure.

On balance sheet netting, banking book

If bank has legally enforceable netting arrangements for loans and deposits, it may calculate exposure values on the basis of net credit exposures according to the calculation it uses for regulatory capital requirements, subject to the same conditions.

No netting between banking and trading books.



Eligible protection

“Eligible collateral” is collateral in which the company has a perfected first priority security interest and is in the form of:

cash on deposit with the covered company (or held by a third party trustee or custodian);

bank-eligible debt securities (other than MBS or ABS);

publicly traded equity securities; or

publicly traded convertible bonds.

“Eligible credit derivative” means a single-name credit derivative or standard, non-tranched index credit derivative, subject to similar qualification requirements for “eligible credit derivatives” under the general risk-based capital rules.

“Eligible guarantee” means a guarantee from an eligible protection provider, subject to similar qualification requirements for “eligible guarantees” under the general risk-based capital rules.

“Eligible protection provider” includes the same entities defined as “eligible guarantors” under the general risk-based capital rules (other than investment grade entities other than insurance companies that predominantly provide credit protection that do not exhibit wrong-way risk and credit unions) and also includes:

SEC registered broker-dealers;

insurance companies subject to state supervision; and

Eligible credit risk mitigation

Eligible credit risk mitigation techniques (“Eligible CRM”) are those that meet the minimum requirements and eligibility criteria for the recognition of unfunded credit protection and financial collateral that qualify as eligible financial collateral under the standardized approach for risk-based capital requirement purposes.

Treatment of maturity mismatches is generally consistent with the approach used in the risk-based capital framework.



non-U.S. broker-dealers and insurance companies subject to comparable consolidated supervision.

See “Recognizing eligible protection” and “Risk shifting” for a description of the implications of using eligible protection.

Recognizing eligible protection

Gross exposure (exposure before netting or eligible protection is applied) may be reduced by the adjusted market value of eligible collateral (subject to a haircut).

Collateral haircut is based on the standard supervisory market volatility haircuts in the general risk-based capital rules.

Gross exposure must be reduced by eligible guarantees and eligible credit and equity derivatives, but not below zero.

Recognizing Eligible CRM

A bank must recognize an Eligible CRM technique in the calculation of an exposure when it uses the technique to calculate risk-based capital requirements provided it meets the conditions for recognition under the LE framework. The amount that must be recognized is:

the value of the protected portion in the case of unfunded credit protection;

the value of the portion of claim collateralized by the market value of the recognized financial collateral when the bank uses the simple approach for risk-based capital requirements purposes; and

the value of the collateral adjusted after applying the required haircuts, in the case of financial collateral when the bank applies the comprehensive approach.

o The haircuts used to reduce the collateral amount are the supervisory haircuts under the comprehensive approach.



Risk-shifting When a covered company uses eligible protection to reduce gross exposure to a counterparty, an exposure to the protection provider must be recognized (up to a cap of the exposure to the initial counterparty).

Risk-shifting/banking book

When a bank is required to recognize a reduction of the exposure to the original counterparty, it must also recognize an exposure to the CRM provider. The amount assigned to the CRM provider is the amount by which the exposure to the original counterparty is reduced except in the case of certain CDS protection (discussed below).

Hedges with maturity mismatches are recognized only when their original maturities are equal to or greater than one year and the residual maturity of a hedge is not less than three months.

Trading book exposures

No separate treatment for trading book exposures.

Trading book straight debt instruments and equity

Accounting value of the exposure (i.e., market value).

Trading book swaps, futures, forwards, credit derivatives, and similar instruments in the trading book

Instruments must be converted into positions following risk-based capital requirements. Instruments are decomposed into their individual legs.

Trading book sold credit protection

Exposure to the referenced name is the amount due if the protection is triggered minus the absolute value of the credit protection.

For credit-linked notes, the protection seller must consider positions both in the bonds of the note issuer and in the underlying asset referenced by the note.



Options in the trading book

Exposure value must be based on the change(s) in option prices that would result from a default of the underlying instrument.

Exposure value for a simple long call option would be market value and for a short put option would be equal to the strike price of the option minus its market value.

In the case of short call or long put options, a default of the underlying would lead to a profit instead of a loss, resulting in an exposure of the option’s market value in the former case and equal to the strike price of the option minus its market value in the latter case. The resulting position will be aggregated and subject to a floor of 0.

Investments in transactions (i.e., index positions, securitizations, hedge funds or investment funds)

Calculated using the look-through approach, as described above.

Offsetting/trading book

Banks may offset long and short positions in the same issue (issuer, coupon, currency and maturity are all identical) for the purpose of calculating a bank’s exposure to a particular counterparty.

Positions in different issues from the same counterparty may be offset only when the short position is junior to the long position or if the positions are of the same seniority.



Hedging with credit derivatives

The hedge may be recognized if the short position is junior or equal to the long position.

A reduction in exposure achieved by a hedge with a CDS requires a shift to the credit protection provider if the CDS provider or the referenced entity is a financial entity. If neither is a financial entity, the exposure amount assigned to the credit protection provider is the counterparty credit risk exposure value calculated under the SA-CCR.

“Financial entities” is broadly defined and includes:

o consolidated groups in which any legal entity is subject to prudential supervision that is consistent with international norms, including insurance companies, broker-dealers, banks, thrifts, and FCMs; and

o unregulated financial institutions, defined as companies whose main business is asset management, lending, factoring, leasing, provision of credit enhancements, securitization, investments, financial custody, CCP services, proprietary trading, and other financial services activities identified by supervisors.

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