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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.
Purpose
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.
EXECUTIVE
SUMMARY
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
Country Risk
Analysis
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.
Multinational
Banks
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:
- Reports from
outside economic research services.
- Published
economic data and analysis.
- Articles
from business publications.
- Situation
reports submitted by country managers and credit officers.
- Call reports
from on-site visits by headquarters managers and credit officers.
- Reports from
the major rating agencies.
- Limit exposure
reports.
- Copies of
documentation approving limits, sublimits, and exceptions to limits.
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.
Regional
Banks
Country Risk
Management Process
Summary Conclusions
- Most of the
regional banks have formal, centralized processes that cover the
management of country risk. Only one bank has a process that is
not the direct responsibility of a senior management committee.
- All but one
of the regional banks have a formal country risk reporting mechanism.
Most of these banks' country risk management groups, report at
varying degrees, to the board of Directors.
- In all of
the regional banks transfer risk is integrated in some manner
with the credit risk or loan approval processes bank-wide, rather
than treated as an independent risk.
- Regional
banks have established country risk rating systems, which in some
but not all cases, correspond to their overall commercial credit
risk ratings.
- None of the
banks integrate the country risk management process with the market
risk management function.
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
complex calculation that considers separate ratings of other, more
discrete factors, such as the economy, country size, and financial
sophistication. None of the banks make any attempt to factor covariance
into their limit setting process. Country exposure limits in the
remaining six regional banks are all expressed as a percent of the
bank's capital based on the risk rating.
In most of the
regional banks, the limit setting process is an annual exercise
(subject to monthly or ongoing reviews in some banks). In addition
to information from the country risk analysis process, proposed
country limits usually reflect a consideration of their marketing
strategy and customer needs. Depending on the bank, country risk
limits may be approved by the chief credit officer, a risk management
committee, the bank president, or the board of Directors. One bank's
limits are approved on a sliding scale based on size with the lowest
approval authority being at the group manager level, followed by
the department committee, division executive, and other executive
level officers.
Most of the
regional banks' country risk limits are based on a certain percentage
of capital. For example, a country rated "1" could have a maximum
exposure of up to 15 percent of capital when a country rated "5"
is limited to a maximum of 1 percent of capital. This process gets
more complex in grades "3-5" when risk indicators (+ or -) are employed
with limit implications (leave a maximum allowed or reduce to a
lower level) pre-assigned.
Limit Compliance
Monitoring Process
Most of the
regional banks have a mechanism for reviewing concentrations and/or
exceptions to their country risk limits. One bank's policy
limits and exposure exceptions are reported to an executive level
committee. Others require that exceptions be approved by senior
officers. Generally, the limit compliance reviews are performed
at least monthly.
Two regional
banks have established a formal contingency or exit plan for dealing
with deteriorating country risk situations. However, most
banks indicate that their normal monitoring procedures enable them
to deal with such situations through risk rating downgrades, shortening
of tenors, freezing of unused lines, and other exposure reduction
strategies.
Marketing Strategies
And Risk Tolerances
Summary Conclusions
- In most of
the regional banks, marketing strategies are established by line
management and approved by the bank's board of Directors or a
board committee.
- Risk tolerances
are recommended mostly by line management or a loan committee
and approved by the boards of regional banks.
- Management
of marketing strategies varies from bank to bank.
In most of the
regional banks, marketing strategies are established by line management
and approved by the bank's board of Directors or a board committee.
At one bank, marketing strategies and risk tolerances are developed
by line management and approved by a board committee. In another
bank, before any foreign markets are approved for business transactions,
the specific bank area must submit a formal request detailing the
rationale for conducting business in a country. One bank that is
fairly new to international lending, is in the process of establishing
a country risk management process. Marketing strategies and risk
tolerances for two banks are set by a loan committee or international
committee and approved by the boards of Directors.
In one bank,
marketing strategies are managed centrally. Another bank's marketing
strategy is managed on a regional basis (e.g., Latin America, EMEA,
Asia, Middle East). Only two banks manage marketing strategies on
a global line of business basis.
Small
Banks
Country Risk
Management Process
Summary Conclusions
- All of the
small banks have developed formal country risk management programs
and use a centralized country risk management approach.
- In all but
two instances, the small banks have adopted formal written country
risk management policies that are board-approved.
- All of the
small banks have adopted formal internal tracking and reporting
mechanisms.
- The small
banks are staffed with experienced managers and support staffs
that are necessary to manage country risk.
Responsibility
for the Process
Most of the
small banks control the country risk management process through
a centralized, formal international department with oversight provided
by a board-appointed committee. In most of the small banks,
responsibility for management of country risk is held by the senior
international department executive officer. In one bank, such responsibility
rests with the senior credit officer, and in another, the chairman
of the board (who is also a principal owner and an active bank officer)
is the responsible official.
All of the small
banks have provided for a level of expertise necessary to manage
country risk properly. The banks are staffed with experienced professional
managers and support staffs. This process is integrated with the
overall credit risk management functions in all cases.
Reporting Mechanism
and Monitoring
Senior international
department management officials provide regular reports to other
senior bank officials, oversight committees, and their board of
Directors. Most of the banks have a committee designated to monitor
and provide oversight over international functions on behalf of
the board of Directors, normally on a monthly basis. In most instances,
the senior international department executive manager reports directly
to the responsible oversight committee with subsequent formal reports
also presented directly to the board of Directors at least quarterly.
Reports presented
to the boards of Directors most typically include:
- Recommended
country exposure limits (for board of Directors approval or ratification).
- A summary
of the bank's exposure levels by country.
- Credit reports,
including lines of credit for approval or ratification.
- Problem accounts
for information purposes and/or action, as necessary.
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