Large Exposures Framework

Definition

The Large Exposures Framework is a BIS Limit framework for measuring and controlling large credit exposures proposed in March 2013 and adopted as a standard in April 2014.

History

The Basel Committee issued its first guidance on credit exposures in 1991.

The large exposures framework complements the risk-based capital standard (Basel II / III) because the latter is not designed specifically to protect banks from large losses resulting from the sudden default of a single counter-party.

In particular, the minimum capital requirements (Pillar 1) of the Basel capital framework implicitly assume that a bank holds infinitely granular portfolios, i.e., no form of concentration risk is considered in calculating capital requirements. This is explained in more detail in the Basel II Model article.

Contrary to this simplification, idiosyncratic risk due to large exposures to individual counter-parties may be present in banks' portfolios. Although through the supervisory review process (SREP) and the Basel II (Pillar 2) concentration risk adjustments could be made to mitigate this risk, these adjustments are not harmonized across jurisdictions, and may not be able to control extraordinary losses from a single counter-party default.

To serve as a backstop to risk-based capital requirements, the large exposures framework is designed so that the maximum possible loss a bank could incur if a single counter-party or group of connected counter-parties were to suddenly fail would not endanger the bank's survival as a going concern.

The Large Exposures framework is an example of a range of model free risk management tools (LCR, NSFR) that were introduced by regulators worldwide on the wake of the financial crisis of 2008.

The implementation date of the large exposures framework is 1st of January 2019.

Definition of large exposure:

A risk position (sum of all exposures to a counterparty or to a group of connected counterparties) that compares to more than 10 per cent of the eligible capital base (Tier 1 Capital). Hence if the capital base is K, a risk position E_i is classified as a large exposure if E_i > 0.10 * K.

Main provisions

Large exposures as per the above definition must be reported to the bank supervisors.
The largest 20 exposures need to be reported anyway
Standalone Banks not belonging to a Group and Banking Groups have a limit on any single large exposure that is no more than 25% of available eligible capital base. Hence if E_i < 0.25 * K for all large exposures.
Exposures to large systemic institutions are singled out for a separate limit. The so called SIFI limit applied to a G-SIB’s exposure to another G-SIB should be between no more than 15% of the eligible capital base (Tier 1).

Issues and Challenges

The limit is rather arbitrary and does not have any adjustment for counterparty risk or likelihood of joint default between counterparties (if they are not connected).
The main data challenge concerns the accurate aggregation of exposures to distinct counterparties across a potentially large banking group. This can be a significant challenge especially for more complex exposures:
- Derivative contracts, where the exposure may vary according to market factors
- Structured products, where the exposure may be as part of an underlying portfolio
The intuitive justification for the framework is that enforcement of such a limit would require four distinct counterparty credit events before Tier 1 capital is exhausted. The implication is that such an event has a probability within the risk appetite of the regulatory framework.
Besides the risk profile of the large exposures themselves, the credit risk of the remaining portfolio is also ignored. E.g., a credit event in mortgage bank is highly likely to coincide with increased losses and capital depletion in direct retail exposures.

References