Many years after the horse bolted the Basel Committee is consulting (for comments by 17 March) on shutting another stable door, this time on what it calls “step-in risk”. 'Step-in risk' is the risk that a bank may provide financial support to an unconsolidated entity beyond or in the absence of any contractual obligations, should the entity experience financial stress
'Step-in risk' is the risk that a bank may provide financial support to an unconsolidated entity beyond or in the absence of any contractual obligations, should the entity experience financial stress.
Consultative Document: Identification and measurement of step-in risk (PDF 432 KB).
Before the financial crisis many banks had moved assets off-balance sheet through special purpose entities (SPEs), and some banks provided financial support to those vehicles during the financial crisis beyond contractual obligations to do so, in order to protect the bank from reputational damage.
The proposals aim at identifying unconsolidated entities that could entail significant step-in risk for banks. Such entities may include mortgage or finance companies, funding vehicles, securitisation vehicles, money market funds and other investment funds, asset management companies, and commercial entities that provide critical services exclusively to the bank.
The proposals then list a set of indicators that suggest the presence of step-in risk between a bank and these types of entity. The primary indicators include situations where the bank provides decision-making (management and/or advice), operations (placing securities into the market) or financial support (provision of capital, liquidity facilities or credit enhancement) to the entity. The proposals also include secondary indicators such as branding, purpose and design, economic dependence of a vehicle on the bank, payments of profits from the entity to the bank, and investor expectations.
Depending on the nature of the step-in risk, the proposed regulatory response is either (a) the regulatory consolidation of the entity identified, or (b) a conversion approach, under which the entity posing step-in risk would remain a third party (unconsolidated) to a bank but the potential step-in risk would be captured using quantitative requirements, based on the potential commitment or exposure that could materialise.
Reasonable rebuttals would be allowed in jurisdictions where step-in risks are mitigated by existing public policy that is enforceable by law, for example where banks are prohibited from providing non-contractual support to off-balance-sheet entities.