7. One possibility is to adopt en bloc the measure of credit risk laid down in the capital exercise for measuring credit risk concentrations. This would mean multiplying each type of risk asset by the weight attributed to it in the Capital Accord. For example, a claim secured by residential mortgage or otherwise collateralised or guaranteed would merit a concessional weighting, while off-balance-sheet exposures would be scaled down according to their conversion factors. Use of the risk-weight structure in the Accord would have the advantage of being already known and accepted and would represent a logical extension of the earlier work. Moreover, the use of the same data base would facilitate reporting.

8. The disadvantage of using the capital weights is that they were in general devised as an appropriate measure of banks' credit risks on a "basket" basis. Since a large exposure measure is concerned with concentrations of risk, the measure of exposure needs to reflect the maximum possible loss from the failure of a single counterparty. The Committee has therefore concluded that to use the capital weights for measuring credit concentrations could significantly underestimate potential losses. It would, for example, mean ignoring credit commitments with an original maturity of under one year, whereas it is highly likely that a client in difficulties would draw down its credit lines. It would also mean relying on the value attributed to collateral or guarantees which, in extreme cases, often turns out to be illusory.

9. It is therefore suggested that the measure of exposure should encompass the amount of credit risk arising from both actual claims (including participations, equities and bonds) and potential claims of all kinds (e.g. future claims which the bank is committed to provide), as well as contingent liabilities. Thus, the measure should include at par value credit substitutes such as guarantees, acceptances, letters of credit and bills; securitised assets and other transactions with recourse; and all other forms of contingent liabilities, notably credit commitments.

10. There is, however, one part of the thinking behind the capital weighting framework which would be appropriate for this purpose, namely that which specifies the conversion factors applied for off-balance-sheet items such as swaps, options and futures, where the creditor is not at risk for the full principal amount but only for the replacement cost. The credit risk in respect of this kind of business can be captured by using the measure of exposure reported for the purpose of calculating the adequacy of capital.¹ However, some supervisors and banks would consider that that measure of risk, while suitable for measuring the credit risk in a portfolio of derivative products, is not necessarily appropriate for large exposure purposes where, as already indicated, a more rigorous measure may be justified.

11. Another question which is difficult to resolve fully is the extent to which securities underwriting commitments should be included in a regular measure of large exposures. The attitude taken to securities underwriting in the capital exercise was that the risk was closer in its nature to position risk vis-à-vis the price of the issue being underwritten rather than to a credit risk vis-à-vis the issuer. ² It might therefore be felt appropriate, at least for a lead underwriting bank and so long as the securities are not actually taken up, to measure such exposures as some proportion of the principal amount underwritten, the actual proportion depending on the character of the market and security in question and the perceived expertise of the underwriting bank.

12. A question arises as to whether the supervision of large exposures should be conducted on a consolidated basis or not. It is sometimes argued that consolidation is impractical since there are a number of banking centres where secrecy constraints make it difficult for subsidiaries to report the data necessary to supervise large exposures on a consolidated basis. The Basle Committee has worked in recent years to strengthen the mechanism ³ for reporting large exposures of foreign offices, but experience shows that exposures can still be overlooked if internal controls are weak, especially if fraud is involved. Moreover, the purpose of controlling large exposures is to guard against the worst case and it would be undesirable to convey the impression that supervisors do not hold banks responsible for the exposures in other parts of the group, particularly if some such exposures are booked in foreign offices beyond the apparent control of the parent. Consolidation of all exposures of the group, particularly including those of subsidiaries which are consolidated for capital adequacy purposes, would therefore seem essential in principle. At the same time, the host supervisor needs to pay attention to exposures which are excessively large in relation to the size of the subsidiary in its territory, since a failure of the customer might weaken that unit to the detriment of the whole group. While exposures of one member of a banking group vis-à-vis an affiliate would normally be monitored by the supervisor responsible for the group's consolidated supervision, host supervisors may still need to be concerned about exposures on parent banks, particularly if they have reason to doubt the effectiveness of the consolidated supervision.

Footnotes

1. Two alternative methods of calculating exposure are permitted in the capital accord. In the original exposure method, the nominal value of each contract is multiplied by a factor which varies according to the type and maturity of the contract. In the current exposure method, exposure is calculated as the mark-to-market value (where positive) plus an "add-on" for potential future exposure.

2. In practice, the pains taken to ensure a successful underwriting mean that the underwriter normally runs significantly less risk than a holder of existing equity or debt securities.

3. Most recently in the Supplement to the Basle Concordat issued in April 1990.