Common Practices for Country Risk Management
in U.S. Banks
Interagency Country Exposure Review Committee
Country Risk Management Sub-Group
November 1998
Common Practices for Country Risk Management in U.S. Banks
November 1998
Contents
Background
The bank regulatory agencies decided in fourth quarter 1997 to review the country risk management processes used by U.S. banks to verify information and update examination guidance.
In October 1997 and March 1998, Interagency Country Exposure Review Committee (ICERC) examiners from the OCC, Federal Reserve and FDIC collected information informally on the country risk management processes employed by a sample of multinational, regional, and smaller banks involved in the ICERC country risk discussion process.
A set of questions (Attachment) on various areas of country risk management was developed by the agencies to guide those examiners in their collection efforts. This information was collected solely in the regular examinations of the banks.
This paper is intended to provide examiners and bankers with a better understanding of the variety of approaches used in U.S. banks to measure, monitor, and control country risk exposures. Information collected is not intended to depict the complete spectrum of country risk management processes used in the U.S. banking system, nor to set forth minimum regulatory requirements for country risk management processes. However, when possible, the paper identifies common elements in the country risk management process elements that should be considered by examiners during the examination of individual banks.
This paper consists of an Executive Summary of Common Attributes of Country Risk Management, followed by sections discussing country risk management processes at Multinational Banks, Regional Banks, and Small Banks.
Overall Conclusion
Country risk management processes and practices vary significantly among U.S. banks . While some general similarities can be identified, large differences exist in how the banks identify, measure, set limits for, monitor, and manage country risk exposures.
Nonetheless, the ICERC’s informal survey identified the following common attributes of existing country risk management processes.
Country Risk Management Process and Policies
-
All banks have developed formal country risk management programs . Most programs are centralized.
-
Banks usually have adopted formal country risk management policies that are board approved.
-
All banks have formal internal country risk monitoring and reporting mechanisms . The type and content of country risk management reporting to senior management, board appointed committees, and the board of Directors vary considerably.
-
Typically,
country risk management is integrated with credit risk management.
However, several large banks integrate country risk management
into their overall risk management process.
-
Responsibility for country risk management generally lies with either a senior country risk officer or a high-level country risk committee.
-
Most bank country managers are responsible for recommending specific country marketing strategies and risk tolerances.
-
Several multinational and regional banks have established procedures to deal with deteriorating country risk situations. But, the most common practice relies on informal communication lines between experienced managers in times of crisis.
Country Risk Analysis
-
Most banks maintain formal country risk analysis files at headquarters, with supplemental files in foreign branches.
-
The content
of country risk files varies considerably. The most common components
of country risk files are: internal analysis of political/economic/social
issues and risks prepared by country risk officers or international
economists; external analysis prepared by rating agencies or consultants;
and officer call memos.
-
No multinational
or regional bank relies entirely on external country risk analyses.
However, several small banks use them as their primary tool to
evaluate country risk.
Country Risk Ratings
-
All banks,
except for one small institution, assign formal country risk ratings.
-
Most banks’
country risk ratings cover a broad definition of country risk,
including transfer risk and local currency/indigenous risks.
-
Few multinational
banks use country risk ratings that focus solely on transfer risk.
-
Although
most banks’ country risk ratings definitions appear to parallel
ICERC’s country ratings
,
direct correlations
are generally unclear. The principal difference is that ICERC’s
rating definitions focus solely on transfer risk and the banks’
definitions on broader country risk issues.
-
Most banks
apply country risk ratings to all types of credit and investment
risk exposures, including local currency lending
.
-
Banks with
mainly short-term trade and bank exposures focus on short-term
country risk issues versus long-term transfer risk issues.
-
In most banks,
country risk ratings are integrated with their commercial credit
risk rating system. Generally, country risk ratings establish
a ceiling for commercial credit risk ratings (i.e., the borrower’s
commercial risk rating can not be better than the country risk
rating for its country of domicile).
-
There is
wide inconsistency in terms of who has responsibility for assigning
country risk ratings. Various alternatives include: a formal country
risk committee, an international economics department, the credit
department, and country managers.
- Almost all multinational/regional banks use their commercial ALLL methodology to cover country risk exposures . Few banks also make an extra annual ALLL provision specifically to cover country risk exposures that are criticized or classified internally. Small banks' country risk ALLL allocation processes are less formal. (Note: all U.S. banks must comply with ICERC’s specific ATTR determinations for value impaired rated countries.)
Country Risk Limits
-
Country risk
limits exist in all banks; but they are determined in a variety
of ways
.
Most banks use a "top down"
approach that treats the country risk limit as a scarce resource.
They factor in the country risk rating. Most large banks use a
"value-at-risk" limit for foreign trading accounts.
Some banks use a certain percentage of capital as a ceiling for
individual country risk limits.
-
Country risk
limits generally are approved either by the banks’ credit department
or country risk committee.
-
Almost all
of the banks’ country risk limits apply to the broad definition
of country risk exposure (i.e., including local currency lending).
Two multinational banks’ country risk limits apply solely to transfer
risk exposures
.
-
Few banks
have country risk sublimits for insured/uninsured exposures, tenors,
and/or types of risk exposure or products.
-
Generally,
most banks do not have formal regional concentration or "contagion"
limits
.
However, some banks monitor informally regional
concentration exposures for Latin America and Southeast Asia.
One multinational bank uses a sophisticated co-variance analysis
to set regional limits for "contagion" risk. Several
others are developing co-variance models.
-
Almost all
banks report country risk limit exceptions to executive management
.
In addition, many of the banks also report exceptions to the board
of Directors or its committee.
Country Risk Management
Summary Conclusions
-
Country risk
generally is integrated with credit risk management under the
responsibility of a senior executive or senior management group.
-
Transfer
risk, considered a significant risk, is incorporated usually into
country risk (i.e., there are generally no separate limits for
transfer risk).
-
Most of the
multinational banks have a formal country risk monitoring process
and some type of reporting to the board of Directors. One bank
has no specific reporting process.
-
Formal country
risk management policies usually are included in the bank’s overall
credit policy.
-
Country risk
management in most banks is centralized; however, few banks have
decentralized management and/or credit approval processes.
Responsibility for the Country Risk Management
Country risk management generally is centralized under the responsibility of a senior executive level committee or unit. However, two banks’ processes, although considered centralized, have a higher degree of de-centralization than most of the other banks. Often those responsible have international lending and credit risk experience.
The process is typically part of credit risk management . The boards of Directors are familiar with the country credit risk management process, but most banks do not require annual reporting or review of this process by the board. In all but one bank, there is some level of regular reporting to the board.
Approval of country risk rating and exposure limits is generally the responsibility of a country risk type of committee . Recommendations for ratings and limits are provided by a variety of senior managers and international credit officers. When applicable, input is provided by on-site country managers and credit officers. Normally, only one country risk management committee exists. However, one bank has two committees, with one responsible for cross border exposures and the other for local currency exposures that are self-funded in local currency by its foreign branches and subsidiaries. Another bank also has two committees. One committee is responsible for capital market exposures (liquid short term) and the other for credit exposures . Only one bank has not established a formal country risk management committee.
Reporting Mechanisms and Monitoring
Although all multinational banks monitor country risk, the methods vary . Generally, concentration limits in the form of aggregate country exposure limits and business and product line sublimits are the primary mechanism used to monitor and control country risk. In addition, routine contact is maintained with foreign office managers and credit officers. Often annual visits to the foreign offices are conducted, or the senior country manager and the senior country credit officer makes at least one annual visit to headquarters, at which time they have extensive meetings with senior management. In the interim, senior officers submit periodic reports to the headquarter’s business units, international department, and credit department.
The level of reporting varies as well . Three of the banks report the annual aggregate country limits to their board of Directors, while one bank had no reporting to the board. Another bank reported potential country risk problems to the board quarterly, or monthly if the potential problems are more severe. Aggregate country exposure limits and business and product line sublimits are communicated widely to international business line and credit officers at the country, regional, and headquarters level. One bank reports international exposure and limits covering all types of risk, including local currency exposure, to top level management officials monthly. Another bank reports monthly all exposures to senior management and the board.
Policies and Procedures
Formal policies generally include country risk rating and limits . Most policies are comprehensive. They are found in the bank’s credit policy manual and updated periodically. At one bank, the policy took the form of an operational manual with additional memos outlining pertinent policy issues. Generally, the country risk policies and procedures are approved by a country risk committee, comprised of the bank’s senior executives, and often by the board of Directors.
Staffing and Organization
The multinational banks generally have some type of country risk management committee that sets policies, approves country risk ratings and exposure limits, and approves limit and sub-limit exceptions . This country risk management committee typically is comprised of headquarters senior executives. For example, the committee can include the chief executive officer, the manager of the international department, the chief credit officer, the senior international credit officer, and the Director of the country risk unit.
The banks generally have some type of specialized staff unit within the headquarters international credit department that is responsible for analyzing country risk and preparing the country rating recommendations. This staff unit is comprised of either senior international credit specialists and/or international economists. Discussions with those persons during the ICERC process indicate that their level of expertise and experience is high. Business managers and senior credit officers in a bank’s country and/or regional offices contribute information and insights for the country risk analysis, recommend country exposure limits and sublimits, and are responsible for operating within the approved limits and sublimits.
Information on country exposure and sublimit usage is compiled by specialized headquarters operations units that also track and report the bank’s exposures by borrower, counter party, product line, business unit, and industry, etc. In some cases, several bank areas monitor the usage of country exposure limits and sublimits. They can include the headquarters country risk staff unit, the senior credit officers in each country, and the senior business and product line credit officers in the international department at headquarters. At one bank, the loan review department annually examines all of the larger individual exposures to foreign borrowers and counterparties in its review of exposures for specific product lines or business units. In another bank, the Credit Review Department prepares a special review covering all exposures to borrowers and counterparties in specific emerging market countries. This department is staffed with former senior credit officers with international experience.
Several of the banks have established specific procedures for monitoring conditions in a deteriorating country. However, most of the banks rely on informal communication lines among experienced managers in times of crisis.
Country Risk Analysis Process
Summary Conclusions
-
All multinational
banks conduct a level of internal country risk analysis and subscribe
to a variety of external information resources.
-
The majority
of the multinational banks have formal country risk files. All
banks keep a level of internal and/or external country risk information.
-
Dissemination
of analyses is maintained at a senior management level.
Formal Process
Annual internal country risk analyses at most banks generally cover economic, political, and social variables and trends. However, two banks place a much higher emphasis on general economic factors. These analyses are based mostly on internally derived data supplemented by external sources. The analyses often are prepared by a special unit within the International Credit Department. At some banks, the unit consists primarily of international economists, while at others it is composed mainly of experienced senior international credit officers.
Written country risk analyses are required for most foreign countries where banks have credit or capital market exposures . The principal exception to this requirement is that some banks monitor country risk developments, but do not prepare an annual written risk analysis for selected low risk OECD countries (e.g., Germany, United Kingdom).
Upon completion of the annual analyses, most banks will segregate the countries into different categories (e.g., risk classes) based on the level of risk . For "high priority" countries, most banks will perform an in-house analysis. For "low priority" countries, most banks use a combination of external economic, political, and social data, etc.
All of the multinational banks subscribe to two or more external economic research services that provide historic and current economic data and ratio analysis and cover political and social factors and trends. The banks that do not have their own staff of international economists make greater use of the information and base line analyses provided by the external sources. However, none of the banks rely solely on external analyses.
When external information and ratings differ from internal analyses, the differences are discussed by the country risk management committee . No other formal due diligence mechanism was disclosed.
Information Requirements
Formal country risk management files are required by most of the multinational banks . In the two exceptions, only informal country files are kept. Country credit and/or limit exposures are maintained separately. Generally, the units or persons who prepare the annual risk analyses keep extensive information on each country that can include:
Communication of Analysis/Results
Internally prepared country risk analyses are proprietary . Distribution is typically at a high level and limited to the staff and management of the unit responsible for their preparation, members of the committee that approves the country risk ratings and their staffs, the International Credit Department, the country manager and senior country credit officer, and for banks that have regional offices, the regional managers, and credit officers. Communication at most institutions is on a need-to-know basis.
Country Risk Rating Process
Summary Conclusions
-
All of
the
multinational banks have a formal country risk rating
process.
-
Most
banks
take a comprehensive view of country risk, but differ on
how specific
risks (e.g., transfer or sovereign) factor into their
country
risk rating system. Two banks focus primarily on
transfer risk.
-
Many
banks
apply single country risk ratings to all types of
exposure. However,
a second rating is used by a few banks for locally
funded exposures.
-
Country
risk
ratings are integrated into credit risk ratings. The
country rating
usually takes precedence.
-
Most
banks’
country risk ratings correspond to ICERC. But, direct
correlations
are unclear because ICERC rates only transfer risk,
while most
banks generally rate overall country risk.
-
Country
risk
ratings are assigned annually by the responsible
governing unit.
-
Validation
of country risk ratings is inconsistent in method and
depth.
-
ALLL
analyses
factor in country risk ratings.
Formal Risk Rating Process
Each multinational bank has a formal country risk rating process. Detailed written policies and procedures for analyzing, recommending, and approving country credit risk ratings are usually included in the bank’s credit risk policy manual. With one exception, banks prepare and assign annual risk ratings for each country when they have more than a nominal exposure. The exception institution does not assign risk ratings to France, Germany, Japan, Switzerland, and the United Kingdom, because it considers their country risk to be comparable with that of the United States.
Banks generally use their country risk ratings to:
-
Develop the
country exposure limits used to manage and
monitor aggregate and
specific asset country risk, or
-
Adjust the
commercial credit risk ratings assigned to
individual foreign
borrowers, counterparties, and securities
issuers by incorporating
the country risk.
Banks conduct an interim review and consider assigning a new country rating (between regularly scheduled annual reviews) whenever a potential change occurs in a country’s rating . Written policies outline the requirements and procedures for those interim reviews of a country’s risk rating.
Covered Risk
Each multinational bank takes a comprehensive view of country risk, but differs in the degree to which they include country specific risks in their country risk rating or in their commercial risk rating system . Banks use either of two general approaches in defining the types of risk covered by their country risk rating. They either define country risk broadly to include all of the country specific economic, political, and social factors that could affect a borrower’s ability to repay its obligations, or they limit country risk to a combination of transfer risk and sovereign risk. Two banks country risk ratings focus primarily on "transfer risk" with the resulting impact on commercial risk ratings.
Every bank, regardless of the approach it chooses, includes transfer risk as a major component of country risk . The basic bank definition of transfer risk is the risk that a country’s local currency will not be convertible into a foreign currency, such as US dollars, required for repayment of loans to foreign lenders (i.e., banks). Banks are expanding their definition of transfer risk to include the risk that, due to currency devaluation, borrowers’ local currency holdings and cash flow, could not be converted into a sufficient quantity of foreign currency to repay their loans to foreign lenders.
The primary measure of transfer risk used by banks is a comparison of the foreign government’s ability to meet its external debt obligations from foreign currency reserves, cash flow, credit lines, saleable assets, and its access to new foreign currency loans . These foreign government external debt obligations are defined to include those of state and provincial governments and their agencies, companies owned by national, state, and provincial governments, and third party obligations of private corporations guaranteed by national, state, and provincial governments. Banks are expanding their measurement of a country’s transfer risk obligations to include the aggregate cross border (foreign currency) debt obligations of corporate borrowers. This trend reflects a recognition that some countries use government-approved foreign currency borrowings by corporations to make it appear that, based on their direct government related external debt obligations, they had less transfer risk.
Banks define sovereign risk to include both the ability and willingness of a foreign government to repay its direct and indirect (i.e., guaranteed) foreign currency repayment obligations . Several cases are cited as examples of countries that were able to repay (or refinance) their foreign currency repayment obligations for a period of time, but were unwilling to do so.
Every bank, regardless of which general approach it chooses, includes in its definition of country risk the potential impact of a foreign government’s economic, monetary and fiscal policies on the ability of borrowers and counterparties to meet their obligations to the bank.
Covered Exposures and Products
Generally, multinational banks’ country risk ratings apply to almost all types of direct and indirect exposures . These can include:
-
Loans to
foreign borrowers
(commercial, project
finance, etc.).
-
Guarantees.
-
Letters of
credit.
-
Foreign exchange
and derivatives counterparty
exposures.
-
Settlement
risk.
-
Securities
of foreign issuers (whether
held in trading, investment
or underwriting
accounts).
-
Local currency
exposures (whether funded
with local deposits or US
dollars).
-
Direct equity
investments such as the book
value of their foreign
branches and
subsidiaries.
-
Trade finance.
-
Investment
banking.
-
Venture capital
investments.
One bank will not make a loan to any company without a hard currency repayment source. Another bank’s rating system divides exposures into three major categories: traditional lending with sub-limits for trade finance, project finance, and Fed funds; traded derivative products; and tradeable assets, mainly bond positions.
Most of the banks assign a single risk rating to each country that focuses primarily on cross border credit risk. In addition to on-balance sheet cross border credit exposures, this single country risk rating is applied directly to:
-
Local
currency
exposures funded by
the bank with U.S.
dollar foreign
liabilities
(i.e., deposits) and
subsequently converted
into local currency.
-
The
on-balance-sheet
equivalent value of
off-balance-sheet
cross border credit
obligations
(e.g., derivatives).
-
Any foreign
asset valued at its
original U.S. dollar
cost or book value
(e.g.,
securities held for
investment and deposit
placements).
Banks recognize that the country risk for local currency exposures funded with local liabilities is less than for cross border claims because there is no transfer risk. Therefore, a few banks have a second country risk rating that covers local currency exposures (i.e., loans) funded with local currency liabilities (i.e., deposits). However, most banks apply their cross border country risk rating to their local currency exposures funded with local liabilities, because the same country's specific economic, political, and social factors that would impair a borrower’s ability to repay foreign currency obligations, are likely to limit the ability of local currency borrowers to repay their obligations. Or, in some cases, the banks believe that two sets of country risk ratings are too cumbersome. One bank’s country risk ratings apply solely to cross border approval and not to local currency lending.
Integration of Country and Commercial Risk
The country risk rating process is integrated closely with the bank’s borrower and counter party credit risk management function . Most banks use country risk ratings that use the same numerical (i.e., 1 to 10) or rating agency alphabetical risk rating categories (i.e., AAA to B) that the bank uses to assess borrower/counter party credit risk. Some banks use a single country risk rating category for most countries risk rated "satisfactory but below investment grade." However, two banks have country risk rating systems that further differentiate "satisfactory but below investment grade" countries. This corresponds to the "best practice" recommended by RMA for borrower and facility credit risk categories. (The process of using narrower risk rating categories is referred to as increasing the "granulation.")
Country risk ratings typically supersede credit ratings. However, at one bank this is true only if the rating is rated "watch" or worse (i.e., a facility in a "pass" rated country would stand on its own credit rating merit). Generally, banks’ country risk ratings automatically also become the commercial credit risk rating for external debt obligations of national, state, and provincial government agencies, and for government-majority owned companies (including banks). Consequently, the credit risk rating for borrowers that are headquartered and operate in a foreign country may not be higher than the country’s credit risk rating.
The country risk rating frequently becomes the commercial credit risk rating for loans to private companies when a strong explicit or implicit commitment is made by the foreign government to support the repayment of its external debt obligations . Thus, a loan to a private borrower that would be rated a "B" based on its own financial strength, but may be protected by a foreign government of a "AAA" country, can also be risk rated "AAA."
However, banks appear to be less willing to upgrade a private borrower’s credit rating based upon the prospect of government support for its debt repayment obligations . This reflects a recognition that domestic economic problems and political considerations may affect adversely the ability and willingness of foreign governments to honor their commitments to support private borrowers’ repayment of their external debt, even when those borrowings required government approval. Banks criticized the rating agencies for assigning less severe credit ratings for the external debt obligations of some private borrowers than the credit risk rating they assigned to the country where the companies are headquartered and do most of their business.
Correlation to ICERC Ratings
Most multinational banks’ country risk ratings generally correspond to ICERC ratings, despite the fact that ICERC ratings only cover transfer risk. Four banks’ ratings do not correspond and one appears to be more conservative. For those that correspond, country risk rating categories are equivalent to the ICERC "Strong," "Moderately Strong," and "Weak" risk rating categories. For example "AAA" and "AA" bank ratings usually are equivalent to the ICERC "Strong" rating category.
The multinational banks like to know whether ICERC rates a country’s credit as "Strong," "Moderately Strong," or "Weak." Though they may not use the ICERC rating for their own country credit risk rating, it helps them to evaluate the reasonableness of their own country risk ratings. There are more inconsistencies between bank country risk rating categories and definitions for higher risk countries (i.e., "BB" to "C", or #7 to #10) and ICERC’s "OTRP," "Substandard," and "Value Impaired" rating categories.
Rating Development Process
Country risk ratings generally are assigned annually to every country where banks have more than a nominal exposure . The responsible governing unit, e.g., country risk management committee or international exposure committee, assigns country risk ratings. Recommendations for ratings come from a variety of sources, including specialized units located within the international credit department that prepare the annual country risk analyses, credit departments, and economic departments.
Multinational banks assign their own country risk ratings rather than relying on a third party source, such as a credit rating agency . Some bank senior credit managers reported that external country risk ratings for emerging market countries are often one half to a full grade too high. For example a country rated "BBB" by the rating agencies might be rated the equivalent of "BB" or "BB+" by the banks.
Rating Validation Process
Country risk committees often will discuss rating differences. For some banks, the Loan Review Department checks to see that country risk ratings are assigned properly to individual credit exposures, but does not validate the individual country risk ratings, because its staff lacks the necessary expertise. Other banks’ Internal Audit Departments review the process used to develop the country risk ratings to confirm that the bank’s policies and procedures are being followed. One bank uses country risk ratings assigned by major credit rating agencies to check the reasonableness of their own internal country risk ratings. Credit agency and bank country credit ratings are similar, but should not always be identical because they measure risk for different types of debt obligations. Most rating agencies focus on sovereign (foreign government) debt while the banks ratings are usually meant also to cover the country credit risk inherent in commercial and industrial debt of companies headquartered and operating in that country.
Factoring in the ALLL Analysis
The multinational banks keep a higher level in their allowance for loan and lease losses (ALLL) account for facilities with higher country risk ratings . Therefore, the bank would increase its ALLL to the extent that the country rating increases the risk rating of a facility. Banks reported that they move quickly to make special provisions to their ALLL when a change in country risk increases the potential for credit losses over the next 12 months. A few banks make an extra annual provision to their ALLL to cover country risk specifically. Exposure concentrations by country risk rating are used to determine the size of this provision.
Country Risk Exposure Limits
Summary Conclusions
-
Formal
exposure
limits
are
set
annually.
-
Exposure
is
managed
through
the
use
of
aggregate
country
exposure
limits;
however,
credit
and
capital
market
exposure
is
not
necessarily
tracked
jointly.
-
Aggregate
and
sublimits
are
recommended
and
reviewed
by
various
levels
of
line-of-business
or
credit
managers
as
needed
and
finally
approved
by
the
country
risk
committee.
-
Various
methods
are
used
for
country
limit
compliance
monitoring.
Formal Limits
Aggregate exposure limits for individual countries, and sublimits for specific products and business lines primarily are used by banks to manage and monitor country risk . Country exposure limits and sublimits are approved annually, but may be adjusted during the year to reflect improved new opportunities and changes in a country’s risk profile. When a bank has a regional office, recommendations for limits and sublimits are reviewed by the senior regional manager and credit officer before being referred to the headquarter’s country risk committee. Written policies and procedures for setting, changing, using, and monitoring compliance with those country exposures limits are found typically in a bank’s credit manual(s).
Exposure Management
Multinational banks set aggregate risk exposure limits for almost every foreign country where they have credit or counterparty exposures . Some banks do not set aggregate exposure limits for "very low risk" countries, such as France, Germany, and the United Kingdom. Aggregate country exposure limits are used primarily to help manage and monitor exposures to emerging market countries. Aggregate country limits do not play a meaningful role in limiting exposures to most developed countries, because global competition already limits the available business.
Banks that have both substantial capital markets (i.e., securities trading and underwriting) and credit related exposures (i.e., loans, letters of credit, and derivative contract receivables) typically set separate aggregate exposure limits for each . Separate limits are used, because the exposures are measured differently for capital markets and credit related activities. The aggregate exposure limits for a country is the lower of the maximum exposure the bank is prepared to permit for that country; or the total of the sublimits for the various products and services a bank offers to customers in that country. There can also be sublimits for local currency exposures.
In some multinational banks, aggregate exposure to a particular country is measured by adding the notional outstandings and commitments for credit facilities, the market value of derivative contracts that are "in the money," and the estimated value-at-risk for trading assets (securities and foreign exchange) . The formulas used to estimate "capital at risk" use a similar methodology. Thus, loans are assumed to require a fixed percent of capital based on their notional amount, but for trading account assets the fixed percent is applied against the estimated value-at-risk (VAR), which is much lower than the notional value of the trading account assets. The banks recognize that this approach to measuring country exposures (and allocating capital) strongly encourages them to conduct larger scale international capital markets activities, to a lesser extent fosters the development of derivatives business with strong foreign counterparties, and discourages foreign lending. One bank now uses estimated potential loss (assuming a payment default) rather than the notional US dollar amount to measure country risk exposure and capital at risk. The effect has been to reduce somewhat the bias against foreign lending and to enable them to use a single comprehensive aggregate exposure limit for each country.
Foreign securities in trading accounts and foreign exchange positions are marked-to-market (usually daily) . Banks believe that this captures a significant portion of the decline in value when country risk increases. The VAR approach is intended to capture the potential additional losses that might be suffered before the securities positions could be liquidated. Several banks reported that they are reviewing their VAR methodology for exposures to emerging market countries. Assumptions regarding market liquidity and the availability of hedging opportunities, though supported by prior experience, were too optimistic in light of recent events in Southeast Asia.
Limit Setting Process
Generally, aggregate country exposure limits are recommended by the international credit department, in consultation with the country managers and credit officers. Exposure limits are approved by the country risk committee, which consists of the bank’s senior executives.
Typically, the request for a country exposure sublimit for a particular product or service is developed by the local business unit manager in consultation with its senior credit officer . These requests are then reviewed and approved by the next higher level of business line management. For most banks, this is the country manager and the senior country credit officer. Final sublimit recommendations would be made by the bank’s international credit department and approved by the country risk committee. Generally, when a bank has a regional office responsible for that country, sublimit requests are reviewed and approved by the regional business managers and credit officers. Such requests would still be submitted to the country risk committee.
Limit Compliance Monitoring Process
The methods used to monitor compliance with aggregate country limits varies. Some banks use a centralized automated system to compile aggregate and business and product line exposure data for each country. A unit within the headquarters credit department would monitor the limits and report to the headquarters country risk committee. In another case, compliance with country business and product line sublimits is monitored by both the country credit officers and a unit within the headquarters credit department.
Approval of excess usage of country limits and sublimits is usually the responsibility of the headquarters' country risk committee. Authority to approve small or temporary overages can be delegated to the international credit department and may be delegated further to senior country credit officers or the senior regional manager and credit officer (if the bank has a regional office).
The banks’ boards of Directors are familiar with the limit structure; however, most do not receive formal limit exception information . Reporting varies as follows: one bank reports all country limits and exposures each quarter; another bank reports all country limits and exposures each month; one bank obtains annual board approval of its country exposure limits; and another bank obtains annual board approval for the annual "potential loss" exposure limit that may be incurred for any non-OECD country. The boards of Directors are usually advised of the bank’s exposure limits and usage for countries where potential problems are anticipated.
Aggregate country exposure limits and business and product line sublimits are communicated widely to international business line and credit officers at the country, regional, and headquarters level . Country managers and credit officers submit weekly, monthly, and quarterly exposure reports to the headquarters business units, its international department, and its credit department. The monthly reports include a comparison of actual and planned exposures. The quarterly reports typically include projected exposures for the balance of the year.
Marketing Strategies And Risk Tolerances
Summary Conclusions
-
Marketing
strategies
and
risk
tolerances
are
established
mostly
by
line
and/or
division
management
and
approved
by
a
high
level
country
risk
management
or
loan
committee.
-
Risk
tolerances
are
recommended
primarily
by
line
management
and
approved
by
a
high
level
committee.
The
methodologies
used
in
the
establishment
of
risk
tolerances
vary
from
bank-to-bank.
Most multinational banks manage marketing strategies and risk tolerances on a global line-of-business basis . At one bank, the primary source of recommendations for marketing strategies and risk tolerances depends on the business line and country. Foreign marketing strategies at another bank are set by the division and local management. Local lending is governed by the bank’s global relationship and emerging markets management groups. In another bank, the line (country managers) recommends limits and strategies and manages risk locally. For another multinational bank, the international credit committee and senior management approve foreign marketing strategies and credit/counterparty risk tolerances. Historically, this bank has had only one general line of business in foreign countries.
Another bank employs a process whereby bank officers cannot transact business in a foreign country without first having insider knowledge of country practices via an established branch or representative office. They also try to hire local people that are well connected within the country, highly experienced and knowledgeable of local companies, accounting practices, legal requirements, and government policies. This bank does not like to make cross-border term-loans. They watch currency values and transferability closely. Another bank’s strategy and risk tolerances are established by line management and approved by the board annually. This bank’s strategy is focused primarily on trade finance activities, and they will not extend direct sovereign exposure.
During the country risk limits setting process at another bank, country managers develop detailed country marketing and risk management strategies. Those documents are summarized into two pages and presented to the country risk management committee. At one additional bank, the foreign marketing strategies are established by line management. Risk tolerances are recommended by the line, but approved by the bank’s executive risk management committee based upon recommendations from another large corporate credit committee.
Country Risk Management Process
Summary Conclusions
Responsibility for the Process
The country risk management processes of the regional banks are centralized and integrated generally in some manner with the credit risk or loan approval process bank-wide . Most of the banks, except one, have a formal senior management committee that is responsible for the country risk management process, either directly or indirectly, through a separate country risk committee that reports to the overall credit risk committee. In one bank, the country risk committee is empowered to make all risk policy decisions that relate to any business activity outside the U.S. The committee is made up mostly of senior officers with such titles as: chief credit officer, chief international credit officer, country risk manager/analyst, and managing Directors of commercial banking and global marketing.
All of the regional banks have experienced management teams with the background and skills necessary to control this area of risk. In most cases, these banks are involved primarily in trade finance activities. However, one bank has considerable experience in sovereign and foreign commercial syndicated lending activity.
Reporting Mechanism and Monitoring
The majority of the regional banks report country risk exposure regularly to the board of Directors, while a few banks provide that information only to the chief credit officer . However, in general, the level of detail of country risk exposure information contained in the board of Directors' reports is unclear. There is little evidence that formal presentations on country risk are made to the board. One bank has not established a formal reporting mechanism to the board or senior management. Reporting is done on an ad hoc basis. However, exposures in two of the bank's subsidiaries are reported to the board regularly.
The U.S. banks that are wholly owned by foreign banks, have adopted the parent bank's country risk management processes. However, these U.S. banks report their exposures to their own boards of Directors as well as that of the parent bank. Furthermore, the boards of these foreign owned U.S. banks are directly responsible for the exposures booked in the U.S. Thus, although the country risk management policies of the foreign owned U.S. banks emanate from the parent bank, the U.S. banks appear to have proper independence and governance over country risk exposures under their own responsibility.
It appears that information on country risk concentrations and/or exceptions to the banks' country risk limits is being reported to the boards of Directors in at least half of the regional banks.
Country Risk Analysis Process
Summary Conclusions
-
All
of
the
regional
banks
have
a
country
risk
analysis
process.
-
Most
country
risk
analyses
are
performed
internally
by
the
banks'
economic
divisions.
They
incorporate
rating
agencies'
analyses
into
their
process.
-
Content
of
country
risk
analysis
files
differs
between
banks.
There
appears
to
be
no
common
standards
for
the
information
required
to
be
maintained.
-
In
general,
information
from
the
country
risk
analysis
process
appears
to
be
widely
disseminated
within
the
banks.
Formal Process
In most of the regional banks surveyed, country risk analyses are prepared by their internal economic research departments . However, two banks rely on country risk analyses that are prepared by their foreign parent banks. Most banks incorporate externally prepared rating agency analyses into their internal processes, but they do not rely on them exclusively. In addition to information received from the rating agencies, one bank uses externally prepared economic research data.
The depth, or level of detail contained in the banks' country risk analyses range from minimal to detailed . In two banks, the depth of analysis is a function of the specific country and its current rating, or the banks' existing or proposed exposure limit for the country. Information on the frequency of reviews was collected at only three of the banks. One of them indicated that they conduct quarterly reviews. The other two perform annual reviews.
Information Requirements
Three regional banks have broadly outlined information that should be found in their country risk files . Some basic information found in their files includes country analyses (internal and/or external), exposure data, publications, news reports from newspapers and the Internet, and other country related data. One bank is still creating its country risk management process, while another does not have file standards and relies instead on the country risk analysis process (and presumably documentation) at its foreign parent bank.
Although two banks indicated that they routinely compared their internally assigned country risk ratings with either ICERC or other external ratings, none of the regional banks have any type of formal due diligence process to reconcile internally and externally assigned country risk ratings.
Communication of Analysis/Results
Generally, country risk analyses are disseminated widely in the regional banks . In two banks, the data is incorporated directly into the banks' loan policy. In two other banks, country risk information is made available on the bank's computer system.
Country Risk Rating Process
Summary Conclusions
-
In
the
regional
banks,
country
risk
is
defined
generally
to
encompass
a
broader
spectrum
of
risks
than
transfer
risk,
although
transfer
risk
is
an
important
component.
-
Types
of
exposure
covered
by
country
risk
ratings
vary
considerably
because
of
the
wide
variety
of
business
activities
conducted
offshore
by
the
regional
banks.
-
Strong
correlation
exists
between
country
risk
rating
and
credit
rating
categories,
particularly
at
the
level
of
classified
assets.
-
The
country
risk
ratings
of
most
regional
banks
correspond
with
ICERC
ratings.
-
Typically,
a
senior
credit
committee
or
the
board
of
Directors
assigns
country
risk
ratings.
-
There
is
no
independent
validation
of
the
country
risk
rating
process
at
most
of
the
regional
banks.
-
In
assessing
ALLL
adequacy,
most
regional
banks
use
their
respective
commercial
credit
risk
rating
and
reserve
allocation
methodologies.
Formal Risk Rating Process
The regional banks assign ratings for countries in which they are currently doing business . None of the banks exclude any countries from this process. Several banks risk rate countries proactively based on potential strategic initiatives.
One bank's risk ratings reflect the level of a country's risk of an event when it is unable to honor its foreign currency denominated obligations. Countries are rated in tiers to conform with the commercial grading system. The overall country risk rating normally will be the lower of the country risk rating or the rating of the foreign borrower. Rating tiers are determined based on ICERC country risk rating definitions, external rating agencies, economic indicators and credit criteria, and political and economic developments in a country.
Covered Types of Risk
Most of the regional banks define country risk to encompass a broader spectrum of risks than transfer risk, although transfer risk is considered to be an important component in the overall country risk evaluation by all banks . Banks typically include economic, political, social, and local regulatory considerations in the broader definition of country risk. One bank, however, reports making the country risk evaluation solely on the basis of transfer risk.
Covered Types of Exposures and Products
Generally, most of the regional banks' country risk ratings apply to almost all direct and indirect exposures . The covered types of exposure generally include:
-
Direct
lending.
-
Money
market
activities.
-
Other
investments.
-
Letters
of
credit.
-
Counterparty
credit
risk.
-
Trade
finance.
-
Investments.
Integration of Country and Commercial Risk
For most of the regional banks, there is a strong correlation between country risk ratings and commercial credit rating categories, particularly at the level of classified assets . However, one bank's country risk ratings are separate with no clear correlation. All banks assign the more severe rating, either credit or country, to monitor asset quality.
All credit exposures are factored into each institution's determination of the adequacy of the allowance for credit losses. None of the regional banks, however, additionally factor in aggregate cross-border exposures or exposures to non-OTRP/classified countries as a separate component of allowance for loan and lease losses.
Correlation to ICERC Ratings
Although most regional banks' commercial risk rating systems appear to correspond with ICERC ratings, the direct correlations are unclear . One bank includes the ICERC ratings in its risk rating system database. Another bank prefers to assign country risk ratings independently without considering ICERC ratings. Another bank's country risk rating policy discusses ICERC's risk rating terminology and the focus on "transfer risk." However, transfer risk is reflected as a sub-category of economic risk, which is a sub-category of country risk.
Ratings Development Process
The responsibility for assigning country risk ratings typically resides with a senior credit committee or the board of Directors . Input and recommendations on the risk ratings come from various sources. In half of the regional banks, the economics department drives or assists in the process. Line departments usually are solicited for additional input or validation.
Most regional banks review country risk ratings from external rating agencies and from ICERC to confirm their views . Several foreign-owned banks also receive the opinions of their parent banks on country risk issues. Those views are considered, but the foreign-owned banks are responsible independently for the ratings and exposure levels, although they are balanced within the global bank structure.
Ratings Validation Processes
In general, the regional banks' country risk ratings are validated independently by either a loan review department or country risk committee . In addition, external sourced country risk ratings, including ICERC ratings, are used to check the reasonableness of the internal risk ratings.
Factoring in the ALLL Analysis
All regional banks factor country risk into their allowance for loan and lease loss (ALLL) analysis. However, the methodologies vary. At one bank, country risk ratings drive commercial credit risk ratings, and the credit risk formula is applied in ALLL evaluations. In four other banks, all loans (domestic and international) are included in the same risk rating system and are factored into the ALLL analysis.
Country Risk Portfolio Management/Risk Limit Systems
Summary Conclusions
-
All
but
one
regional
bank
applies
their
country
exposure
limits
to
the
broader
definition
of
country
risk.
-
In
most
of
the
banks,
the
maximum
level
of
exposure
permitted
for
any
given
country
is
a
function
of
the
assigned
country
risk
rating.
-
A
variety
of
approaches
exist
in
setting
limits.
-
Most
regional
banks
have
a
mechanism
for
reviewing
concentrations
and/or
exceptions
to
their
country
risk
limits.
Formal Limits
In most of the regional banks, the exposure limit for a particular country applies to all types of exposure . However, exceptions to this general rule were noted in four banks, which have excluded, or established separate limits, for one or more of the following types of exposure: foreign exchange, the investment portfolio, settlement risk, or locally funded indigenous exposures.
Some form of country risk sublimits exist in more than half of the regional banks, where separate limits for maturities over one year are most frequent . Although none of the banks have established separate, formal limits for regional concentrations of risk, several consider regional concentrations in their country-by-country limit setting process.
Exposure Measurement and Limit Setting Process
The basis for setting country risk exposure limits varies among the regional banks . In most of the banks, the maximum level of exposure permitted for any country is a function of the assigned country risk rating. In two banks, however, the setting of exposure limits involves a more