Even banks with strong capital ratios may fail as a result of the sudden failure of a counterparty or group of connected counterparties. To address this risk and to complement the now near-final Basel III framework, the Basel Committee on Banking Supervision has published its final standard on “large exposures” which aims to ensure that exposures to counterparties are appropriately monitored and limited. The final standard will provide a degree of relief and flexibility to US and EU banks given the stricter standards proposed last year. However, requirements to conduct onerous assessments remain, particularly as regards the due diligence of exposures when investing in structures with underlying assets.

Rules limiting the size of a bank’s concentration of exposures to a counterparty have historically been among the most important prudential rules, in particular for smaller institutions or local subsidiaries of larger banking organisations. Under the Basel II standard, a bank was required to have capital of at least four times its largest single exposure. In other words, its largest exposure could not exceed 25% of its regulatory capital. For certain institutions this could be quite restrictive as for larger loans the risk-based capital requirements might amount to 5-10% of the loan amount but the large exposure restriction could in effect require the bank to have more capital supporting that loan. In many circumstances the final standards will be even more restrictive as a result of the tightening of the calibration to Tier 1 capital only.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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