New Step-In Risk Guidelines

It has been a long time since we have blogged on this channel, a whole year, that is way too long in the world of banking and risk management. There has also been a lot of requests to bring this portal back into action, so without further ado, we'll attend to that with this new posting on Step-In risk.

Step-In Risk

A few weeks ago the Basel Committee on Banking Supervision released a consultative document on how to identify and manage Step-In risk. In this short blog posting we will take a look at what Step-In Risk is and the recommendations more broadly.

Before digressing on the guidance, I suppose it would be prudent to define this risk class in the context of banking, and the BCBS have captured the scope as ... 

"Step-in risk” is the risk that a bank decides to provide financial support to an unconsolidated entity that is facing stress, in the absence of, or in excess of, any contractual obligations to provide such support."

Step In Risk | Bank for International Settlements

The Bank for International Settlements consultative document can be found here LINK and it has some interesting considerations for risk managers that have to standardise the way in which their organisations address Systemic Tail Events.

Basically, the narrative runs the following way. You have a commercial relationship with an entity you trade with, perhaps they are a customer, or even an investor in your own firm and something goes wrong, catastrophically wrong with this company. To save them from peril, your business decides to "Step-In" with support, liquidity, operational assistance or a contingent guarantee, perhaps many of these things in various forms and much more.

From the outset, Step-In risk would seem to be a good step in the world of risk management (no pun intended) but such benevolence can also come with its own opportunity costs and Step-In support needs to be tempered in line with the failing entities (there can be more than one) direct needs. The "encompassing effect" from Bailing-In to help out as the Bank for International settlements puts it, may spawn on various unwanted outcomes for the caregiver that includes but is not limited to reputation damage.

It doesn't stop there as one can imagine and when dealing in this fantasy-like tail event space, we can expect uncharted paradoxes to rear their ugly heads as the saying goes. Here are a few obstacles that also need careful treatment.

» Banks that aggressively and successfully cross-sell both on-and off-balance sheet products with their clients through a "branded house" strategy ... give rise to a conflict of interest.

» Entities in jurisdictions where banks are obliged by law to ensure that particular investment products are appropriate ... may find themselves trading illegally.

» Exposures already recognised in capital through recognition of associated contingent liabilities ... end up being double counted.

» Entities where a rating agency assigns that entity a better rating than would have been the case without considering the relationship ... have potentially and inappropriately manipulated relationships.

This is going to make for tricky and possibly incomplete guidance but in section 5.1, the BCBS have attempted to stipulate explicit policies and procedures for identifying and managing Step-In risk. Jump to page 15 if you want to know what has to be in place to comply with this recommendation but banks should establish a strategic process for assessing not only a due diligence position from supporting an entity but the potential knock-on effects from choosing to do so.