By now, all of us are aware that the upcoming Single Counterparty Credit Limit (SCCL) rule will impact large domestic and foreign financial institutions. The final rule applies to all U.S. global systemically important banks (GSIBs), U.S. bank holding companies (BHCs) and foreign banking organizations (FBOs) with total consolidated assets of $250 billion or more and U.S. intermediate holding companies (IHCs) with total consolidated assets of $50 billion or more.
Delving into the compliance requirements, we discovered that the SCCL rule approved by the Federal Reserve Board (FRB) could cause financial institutions (FIs) a few head-scratching moments. Here are the top five SCCL conundrums that may provoke some questions and need a conversation or two in your FI.
1. Deciphering Economic Interdependence
Economic interdependence requires that exposures be aggregated across certain counterparties. This criteria is applicable when the exposure to the principal counterparty exceeds 5% of a bank’s tier 1 capital.
In plain English, for example, this applies when FI-‘A’ is a mortgage originator and FI-‘B’ is buying more than half of their mortgages for pooling and securitization purposes from ‘A’. An exposure to ‘B’ exceeding 5% of tier-1 capital would also be viewed as an exposure to ‘A’. Exposures across ‘A’ and ‘B’ would be aggregated and viewed as a counterparty group. FIs, then, may need to ask themselves several questions in order to decipher this economic interdependence, including:
- How many third-party inter-relationships exist within a bank?
- How are such credit risks viewed by the organization?
2. Credit Risk of Partially Owned Entities
FIs may also be connected via ownership structures related to controlling interests. The FRB SCCL rule states that when the exposure to the principal counterparty exceeds 5% of a bank’s tier-1 capital, an assessment of a control test must be performed. This control test determines if the principal counterparty has 25% voting control or majority control of the board of directors in one or more companies. If the control-test criteria is met, then the exposures across the connected entities are aggregated. So, pertinent questions for an FI to ask would include:
- How many counterparties are present in an FI where such conditions exist?
- What credit-risk guidelines exist today?
3. The Unknowns of Contagion Risk
The financial services landscape has evolved such that there are a few large providers of certain services, such as securities financing. Thus, it is important to develop a point of view about contagion risk: In the event such a large provider defaults, what are the knock-on effects impacting the FI and its exposures to other FIs?
4. Impact on Other Credit Reporting
SCCL reporting is related to Basel III Capital and RWA reporting in that both require the assets containing counterparty credit-risk be identified at the individual exposure-level and matched to credit-risk mitigants, such as collateral, guarantees and credit derivatives. However, this may pose unique challenges in the sense that a credit-risk mitigant may reduce the overall exposure from a Basel-III perspective, but may add exposure to a specific counterparty from an SCCL standpoint. Thinking about this, an important question becomes: How will FIs ensure consistency of reporting credit-risk mitigants across their enterprise?
5. The Circular Logic of Buying Credit Default Swaps (CDS)
One way to manage credit risk is to purchase a CDS against the exposure. This action may add to the current exposure to that FI, resulting in a move to pare down the exposure to it. Thus, a new question arises: What CDS exposures currently on the books may exceed the FI’s internal credit-risk threshold limits?
The Challenges Ahead — Getting Started
All U.S. GSIBs, major FBOs and IHCs must comply with the final rule by January 1, 2020. That leaves only the balance of 2018 and 2019 to address many questions and develop credit policies and procedures prior to filing FR 2590, the first SCCL form. SCCL reporting requires using specific counterparty related identifiers and parent-subsidiary hierarchies typically not used in other reporting. As a result, incorporating this data, along with the need to aggregate exposures across counterparties determined to be connected, pose a unique set of data and operational challenges for FIs to address.
Financial firms should not underestimate the operational challenges they need to address to comply with the rule’s requirements. To successfully get the SCCL ball rolling — contact AxiomSL to start a dialogue on the ‘risky risk’ of counterparties.