“Step-in risk” is the risk that a bank provides financial support to an unconsolidated entity that is facing stress, over and above any contractual obligation to provide such support, for example to reduce reputational risk.
Step-in risk crystallised during the financial crisis as some banks supported connected but unconsolidated entities, including providing credit or liquidity support to securitisation conduits, structured investment vehicles, and money market funds.
The Basel Committee consulted on step-in risk in December 2015 and has now issued a second consultation paper for a short (60 day) consultation period, focusing on the supervisory reporting templates and to clarify some issues. The paper is regarded as being near-final (PDF, 332KB).
To some extent this problem has been addressed through post-crisis regulatory reforms, such as the revised securitisation framework (which limits the scope for risk transfer and recognises the undrawn portion of liquidity facilities granted by a bank); the liquidity coverage ratio (which recognises the potential loss of funding of asset-backed securities, excludes assets managed by step-in entities from the stock of high quality liquid assets, and calls on banks and supervisors to determine the liquidity impact of contingent funding obligations); the capital treatment of banks’ investments in funds; Pillar 2 guidance on capital add-ons for reputational risk and implicit support; and the principles for sound stress-testing practices.
However, the Basel Committee considers that step-in risk still exists and requires a more structured and forward-looking approach, also covering situations that may be different to those seen in the past.
Banks will therefore be required to undertake (and report the results to their supervisors using prescribed templates) a self-assessment of step-in risk:
The primary focus here is on mitigating potential spillover effects from the shadow banking system to banks, and therefore on situations where a bank acts as a sponsor of an entity, or is a debt or equity investor in an entity (other than through regular lending or market-making activities, in particular for entities undertaking insurance, securitisation and other structured finance, and net asset value funds. However, the scope of application includes any material entities not subject to regulatory consolidation.
Supervisors are then expected to review a bank’s self-assessment and decide whether there is a need for any additional supervisory response, such as a Pillar 2 capital add-on. Basel requirements although technically not binding immediately on banks do offer insights into supervisory expectations of best practice and also ultimately inform the EU rule makers.
Clearly step-in risk is of some importance, but these Basel standards could be highly burdensome for banks to comply with, not least given all the ways in which post-crisis regulatory reforms have already addressed many types of step-in risk and have improved transparency.