Transfer risk in U.S. banks.
The growth of international lending by U.S. banking organizations, especially during the last decade, has added new dimensions to the responsibilities of the federal regulatory agencies that supervise the operations of U.S. banking organizations. As a matter of general approach and philosophy, the agencies seek to apply the same criteria to evaluate both the domestic and the international activities of banking organizations. Evaluating international transactions, however, demands special procedures that take account of "country exposure"--that is, the amount of lending to a country--and of "country risk"--that is, the possibility that adverse economic, social, or political developments in a country may prevent that country, its businesses, and other local borrowers from making timely payment of interest or principal to creditors in other countries. The expansion of international lending has made an analysis of country risk an essential element in the overall evaluation of the financial condition of the largest U.S. banks.
A component of country risk is "transfer risk," which arises when borrowers incur debts denominated in the currencies of other countries. Specific government policies, general economic conditions in a borrower's country, or changes in the international environment may prevent that borrower from obtaining the foreign currencies needed to service its debt. Whatever the cause, foreign currency may not be sufficiently available to permit the government and other entities of the country to service all their foreign debt. In such circumstances, the condition of the lending banks suffers.
THE SUPERVISORY SYSTEM
In 1978, the three regulatory agencies--the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation--jointly developed an approach to improving their supervision of the transfer risks inherent in foreign lending by U.S. banks. The new system was designed to address transfer risks separately in the bank examination process, rather than attempt to analyze them in the supervisory framework that is used for evaluating commercial risks. A common supervisory approach was needed for two other purposes: to ensure that the bank regulatory agencies treated transfer risks uniformly; and to improve the quality and efficiency of regulatory review by drawing on and coordinating the best available expertise. The system was built around a process for reporting country exposure that had been adopted a few years earlier. This supervisory system has four parts:
1. The identification in examination reports of significant country exposures to bring to the attention of bank management exposures that are large relative to an institution's own capital.
2. Comments by the agency on large exposures to individual countries based on a country's economic condition and on the relation of the bank's exposure to its capital funds or to the exposures of its competitors.
3. The identification, or "classification," of exposures to countries with debt-servicing problems.
4. A review of the bank's policies, practices, procedures, and controls for managing country risk.
Like domestic lending, loans to individual foreign borrowers are subject to legal lending limits, but otherwise the agencies do not prohibit lending to any country per se. Bank regulators want assurance, however, that the bank's management and directors are aware of significant exposures and that reasonable procedures are in place to evaluate the risks.
As the volume of international lending grew during the 1970s, the regulatory agencies needed more complete and accurate data about the level of bank exposures. They also needed to ensure that all banks that engaged in lending to foreign borrowers had sufficient information on aggregate lending to make informed decisions about portfolio diversification. The Country Exposure Report (form 009 of the Federal Financial Institutions Examination Council) was developed in 1976 to provide that information; it has become a key source of data on country exposure for the agencies, as well as for many commercial banks and other interested parties. Initially, banks reported on a semiannual basis, but they began to file quarterly reports in 1984, as required by the International Lending Supervision Act of 1983. As a general rule, a U.S. commercial bank that has $30 million or more in foreign lending must file the report.
The report currently consists of 24 different items of information on lending and covers almost 190 countries. A bank first lists the amount of credit it has extended to borrowers in a country and then provides information on any guarantees by parties in other countries. The report also categorizes the loans by their remaining maturity and by the sector of the borrower (bank, public, other). It lists the amount of lending in the local currency provided by the bank's local offices and the amount and nature of certain contingent liabilities. The focus of the report is the "adjusted" exposure, the result of transferring the bank's claims from the country of the "initial" borrower to the country of the guarantor (if any) and, in the case of claims on foreign branches of banks, to the home countries of those banks. Analysis of the various items reported and of the results of these adjustments indicates the location of the country risk in a bank's portfolio.
These individual reports are used to evaluate the exposure of the reporting institutions. The agencies hold them in confidence, but much information about foreign exposure remains available to the public. Specifically, banks must disclose their large exposures in annual reports to their shareholders and in other regulatory reports. For this purpose, large exposures are defined as those representing more than 1 percent of the bank's assets or more than 20 percent of its primary capital. Moreover, each quarter, the Federal Reserve Board's statistical release, "Country Exposure Lending Survey" (E.16), makes available to the public a substantial amount of information about the foreign exposure of U.S. banks to individual countries. It provides the information for all reporters combined and also for three subgroups separately: the nine money-center banks, a group of large regional banks, and all other reporting banks.
Aggregate data are used principally in making supervisory and regulatory policy, but they are also used for identifying the aggregate borrowings of foreign countries from U.S. banks. In addition, the Federal Reserve submits total figures on U.S. bank lending to each country to the Bank for International Settlements in Basle, Switzerland, where they are combined with similar data from banks in other major countries. These BIS statistics, in turn, provide the public with information about worldwide lending and borrowing trends.
In connection with the country-risk procedures adopted in 1978, the agencies established the Interagency Country Exposure Review Committee to assess transfer risk and to ensure uniform treatment of the risks during examinations. The committee consists of three voting members from each agency: a staff member from the agency's Washington office and two of its senior field examiners who have broad experience in international banking.
The committee meets three times each year to review conditions in countries where transfer risk to U.S. banks is significant. Formal economic analyses of each country are presented to the members by economists from the U.S. Treasury, the Federal Reserve Bank of New York, and the Board of Governors. In addition, the examiners recount views expressed and actions taken by major money-center and regional U.S. bank lenders with whom they met prior to the meeting. Drawing upon this information and using standards promulgated by the agencies, the members evaluate the transfer risk inherent in U.S. bank loans to borrowers as a group in each country discussed.
CATEGORIES OF RISK
A number of broad categories are used to evaluate transfer risk. The first three apply to loans in countries that do not have current or imminent debt-service problems, according to the evidence available at the meeting. These categories divide the countries according to potential risk. The remaining categories apply to countries that already pose transfer risk.
Categories of Potential Problems
Countries that are evaluated according to their potential for transfer risk can range from developed countries and countries with strong balance of payments positions to countries with relatively weak balance of payment positions or other problems that could, unless addressed properly, lead to debt-servicing problems. The categories characterize the country as "strong," "moderately strong," and "weak" according to the degree of transfer risk it poses. these three categories are used only for determining whether a particular concentration of exposure warrants comment in the examination report.
Categories of Current Problems
Four other categories are used to identify credits that currently exhibit transfer-risk problems. However, for borrowers in these categories the committee often distinguishes between credit related to trade financing and credit for other purposes because even countries in severe economic difficulty usually give priority to servicing their international trade. Once credits are placed in one of these categories, a more favorable evaluation is not applied until the country has demonstrated a sustained ability to service its debts in an orderly manner. Its economic position, especially with respect to its external accounts, must also show improvement.
The first three categories are various levels of "classification," and they cover the loans subject to the more serious transfer risks.
The first category of classification, "losses," applies to loans to borrowers in countries that have repudiated their obligations to banks, the International Monetary Fund, or other lenders, or in countries whose payment records and economic conditions have deteriorated to the point that any payment is unlikely. The net carrying value of such loans must be reduced to zero.
The second category of classification, "value impaired," covers loans that the lender should not carry at face value. Loans to borrowers in a country with protracted arrearages, as indicated by at least two of the following conditions, receive this evaluation: the country of the borrower has not paid full interest for at least six months; it has not complied with an IMF-supported or similar program and has no immediate prospects for doing so; it has not met its obligations on rescheduled debt for one year or more; or it has no definite prospect for an olderly restoration of debt service.
When an asset receives this classification, the agencies require the lender either to charge off a certain percentage of the original claim or to establish an equivalent specific reserve, called an allocated transfer-risk reserve, that is not considered part of bank capital when measuring capital adequacy. The ratio of this reserve has ranged from 10 percent to 100 percent.
The least serious of the classifications is "substandard." It applies to loans to borrowers in countries that have not complied fully with their external debt obligations, have not adopted satisfactory reform programs, and have not negotiated a viable rescheduling agreement with their lending banks and appear unlikely to do so.
A final category of transfer-risk problems is labeled "other transfer-risk problems." Credits are placed in this category when transfer-risk problems have prevented borrowers in the country from fulfilling their obligations to service external debt, as evidenced by arrearages, forced restructurings, or rollovers. The country is, however, taking steps to restore debt service through economic reforms, which are usually part of an IMF-supported program. Two other kinds of credits fall into this category: those that are being serviced as scheduled but on which an interruption is deemed imminent; and those that have previously been categorized in one of the three classifications just described but for which classification is no longer warranted in light of recent improvements in debt-service performance. Such loans are ones that are viewed as subject to more than normal risks, but not enough to be "classified."
Examiners use the evaluations of transfer risk by the Interagency Country Exposure Review Committee in judging the overall quality of a bank's assets. They must also consider commercial risk factors. If the examiner believes that the business risks a commercial borrower poses dictate a classification more severe than the transfer risk does, then that more severe classification is applied. After this adjustment, classified foreign loans are added to classified domestic loans as part of the process of determining the overall quality of the bank's assets and the adequacy of its capital and reserves.
Examiners may also comment in their reports about a bank's concentration of exposure to a particular country relative to the bank's capital funds. they are required to do so if lending to a country designated as "weak" for transfer-risk purposes exceeds 10 percent of the bank's total capital or if, for a "moderately strong country," the exposure exceeds 15 percent of capital. They do not ordinarily comment on exposures to borrowers in "strong" countries.
These examination comments consist of two paragraphs. The first contains a brief statement on conditions prevailing in the country and on the country's performance under any IMF-supported program. The interagency committee prepares this paragraph. The examiner prepares the second paragraph. It describes the nature of the bank's exposure (such as maturities and types of borrowers) and identifies trends in that exposure. When it is relevant to do so, the examiner may compare the bank's exposure with that of other banks (without revealing identities) and may also discuss the bank's plans for lending to the country.
Identifying and commenting on concentrations of credit to borrowers in any one country are important elements of bank supervision in the United States. When appropriate, the comments should prompt senior management and the bank's board of directors to review their lending policies and exposures. In some cases, the bank may revise its strategy about the nature and amount of lending to borrowers in such a country. If an examiner determines that the exposure is particularly high (relative to risk factors), or that the management of international risk poses other problems, he or she may call attention to those findings in the summary of the examination and also in the letter transmitting the examination report. In that case, the bank's board of directors is required to review and formally respond to the examiner's concerns.
Examiners also evaluate the procedures the bank uses to manage and control its international lending program. Specifically, they review three aspects of the bank's systems: (1) the measurement and monitoring of country risk; (2) the procedures for establishing and changing limits on lending to any one country; and (3) the procedures for evaluating overall country risk. Any material deficiencies in these areas are also criticized.
The approach the federal bank regulatory agencies take to evaluating international lending integrates concerns about transfer risks into the overall evaluation of a bank. The Interagency Country Exposure Review Committee enables the agencies to centralize decisionmaking, ensure uniform treatment of foreign lending, and conduct an efficient supervisory review of transfer risks. The related examination procedures ensure that both the supervisory agencies and bank management recognize significant transfer risks when evaluating concentrations and the overall condition of the bank.
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|Title Annotation:||borrowers incurring debts denominated in the currencies of other countries|
|Author:||Houpt, James V.|
|Publication:||Federal Reserve Bulletin|
|Date:||Apr 1, 1989|
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