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BUSINESS
Securities Valuation by Foreign Banks: What Do Bank Regulators
Look for?
By
Joseph Blalock, Senior Consultant
Editors Introduction: Regulatory supervision of banks around
the world has evolved dramatically over the past 10-15 years. Rather
than the static, audit-type oversight practiced years ago, today’s
bank supervisors in the U.S. and other countries are forward-looking,
focused primarily on a bank's ability to identify, evaluate, and
manage risk throughout their activities. And rather than intermittent
contact with regulated institutions, today’s supervisors are
increasingly engaged in ongoing dialogue with them, moving toward
a model that is sometimes called “continuous supervision.”
Internationally, supervisory standards themselves have been raised
and made more consistent worldwide – due importantly to “best
practices” work by the BIS-sponsored intergovernmental Basel
Committee on Banking Supervision. It’s also true that intensified
bank supervision is partly a product of notorious cases in the 1990s
of inadequate or “evaded” supervision – think of
BCCI, Daiwa Bank in New York, certain Asian and Russian banking
problems a few years ago, and numerous money-laundering scandals.
For foreign banks operating in the U.S., the bottom line now is
that they need to make a proactive, focused effort to understand
what U.S. supervisors expect of them, and why – whether it
be sufficient technical expertise in handling credit and market
risk; a fully effective system of internal controls; or robust corporate
governance throughout their organization. Their ability to build
sound regulatory relations, through solid performance that wins
the trust and confidence of supervisors, can now be one of their
greatest assets.
As a case in point, the following article, based on the first-hand
experiences of a bank consultant, examines the regulatory/supervisory
dimensions for foreign banks in properly pricing non-U.S. securities
held in their portfolios.
As part of prudent management and maintaining their profitability,
banks must be able at all times to determine the current market
value of securities they hold. Market prices on recent trades are
typically the best indicators, but many factors can alter securities
values over time, including fluctuations in the general level of
interest rates, changed perceptions of the quality of businesses
in specific industries or regions, and the changing creditworthiness
of the securities issuer. Additionally, market liquidity is an important
consideration, since a bank may have to sell some portion of its
securities or loans to meet liabilities or other commitments. Since
banks typically hold securities ranging from liquid, high-grade
government and corporate paper to less liquid, unrated debt, bank
regulators are naturally very interested in how well banks monitor
and manage the quality of their securities and credit portfolios.
Many foreign banks and banking offices operating in the US are in
the unusual position of holding obligations of home-country issuers
that do not otherwise have a significant financial presence in the
US. If they buy bonds or instruments such as a share of a loan syndication
for a home country customer, the foreign bank must demonstrate to
US regulators that it has the capability to verify the pricing of
corporate debt and credit-related instruments of these home-country
clients.
Among the illiquid and unusual financial instruments referred to
are corporate and convertible bonds, and other credit-linked notes
and derivatives. These instruments might be US dollar-denominated,
but trade infrequently on US debt markets. Therefore, pricing information
may be unavailable from standard services such as Bloomberg; and
even if available, this information may be unreliable and/or volatile
if the instruments are thinly traded.
To maintain adequate information, the foreign bank would typically
have to augment market trade information with dealer quotations
and “indicated” prices of these and similar securities.
Indicated prices are approximations of what securities dealers expect
market prices may be, but are not necessarily a firm price to buy
or sell that security.
It is not uncommon for US regulators to scrutinize closely how a
foreign bank evaluates both the pricing of obligations and their
overall risk to counterparties that are clients, or affiliates of
clients, of the head office. Two key areas of US regulatory concern
include the foreign bank’s internal controls related to pricing
securities in general, and pricing of securities and other capital
markets exposures of institutions that are also major loan clients
of the head office.
In anticipating this concern, the bank – if it relies on updated
dealer quotes for repricing – should have information from
multiple dealers. This is especially true if the bank would otherwise
be relying solely on quotes from the dealer from whom the banks
purchased the security, since that dealer may be perceived as having
a conflict of interest regarding securities it has underwritten
or sold in the past. Nor should the pricing information come from
the issuer. Regulators prefer there be at least three independent
sources of prices, if possible. If it is not possible for the bank
to reliably obtain prices using dealer quotes or a market data service
provider, the bank may want to use a financial model, which, if
properly documented and validated, can prove acceptable to regulators.
(This model should be based upon the appropriate market interest
rate or other underlying index for the security plus historical
factors such as yield curve spreads to support the model’s
estimate proxies for market prices.) If the foreign bank is simply
not able to periodically reprice certain unusual securities due
to lack of information, then the voluntary establishment of a valuation
reserve may be considered a prudent move by the regulator.
Whatever pricing regimen the bank chooses, another major control
issue is that assumptions must be verified independently by the
risk management or internal audit departments. Regulators expect
to see there is a clear separation between the lines of business
that trade in securities and those that do accounting or subsequent
valuation. The internal third party should also be sufficiently
familiar with these financial instruments to undertake the pricing
verification, and, if necessary, to challenge assumptions about
the prices paid. For example, the independent party should be able
to understand the initial trading or hedging strategy and report
to senior management as to whether these trades were done “at
market” and, subsequently, whether the assumptions underlying
the trades are still valid.
When purchasing securities from head office clients, and when evaluating
whether to continue holding such positions, the US-based foreign
bank should maintain documentation as to why they are holding these
particular securities and how the securities fit within the US bank’s
risk and return objectives. Regulators look for assurances the US
arm of the foreign bank is not buying securities of a head office
client without undertaking adequate due diligence at the time of
the initial transaction or initiating follow-up price monitoring
to measure and manage risk exposure.
An issue of emerging regulatory, investor, and ratings agency concern
is how financial institutions monitor concentrations of credit risk.
The credit exposure of bonds, convertibles, and other credit-linked
notes comprise part of the bank’s overall risk exposure to
a client, with remaining exposure stemming from lending and trade
credit instruments to the same client, as well as the replacement
cost of relevant market derivatives. Foreign bank offices in the
US are often unable to manage locally their entire exposure to particular
corporate clients, or to groups of affiliated clients (“names”,
in regulatory parlance), because their head office organizations
control the global management of credit concentrations. However,
the US-based entity should be able to demonstrate to its US regulators
that it monitors its own total exposures to particular “names”
so as not to have an excessive concentration within its US operations.
The US-based bank would also want to demonstrate to its regulators
that it effectively communicates with its head office in a timely
manner about any increases and curtailments in overall exposure
to the consolidated firm.
Since corporate debt increasingly takes the form of capital markets
instruments, US regulators and many other interested parties –
such as auditors, ratings agencies, and correspondent parties –
are keenly interested in how well banking institutions are monitoring
and measuring the value and extent of overall credit risk.
Foreign banks operating in the U.S. thus need to give full weight
to understanding and dealing with these concerns, and should position
themselves proactively to deal with them.
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