14. In defining related counterparties, it is insufficient simply to consider groups which produce consolidated accounts. Relationships can include, for example, connection through common ownership, control or management. Cross-guarantees may be another indication that counterparties are related. Supervisors may wish to consider as a suitable example the definition used in the European Commission's Recommendation of December 1986 ⁵, namely that a group of related clients means "two or more persons, whether natural or legal, holding exposures from the same credit institution and any of its subsidiaries, whether on a joint or separate basis, but who are mutually associated in that:

1. one of them holds directly or indirectly power of control over the other; or
2. their cumulated exposures represent to the credit institution a single risk in so much as they are so interconnected with the likelihood that if one of them experiences financial problems the other or all of them are likely to encounter repayment difficulties. By way of example of such interconnections the credit institution should take into consideration the following:
   • common ownership;
   • common directors;
   • cross guarantees;
   • direct commercial interdependency which cannot be substituted in the short-term."

15. One of the difficulties in identifying related lending is that customers sometimes go to great lengths to disguise linkages between two or more parts of the same empire. Since most banks already apply counterparty exposure limits of their own, designed to prevent excessive concentration, they already have experience in detecting subterfuges designed to disguise relationships between borrowers. Supervisors need, nonetheless, to make sure that banks in practice exercise due diligence to uncover misrepresentations by customers and to identify related exposures.

16. In isolated cases, banks may deliberately conceal from their supervisors that they are taking on exposures known to be related. In such cases, the management of the bank often has a connection with the borrowers. This is tantamount to fraud and is difficult to prevent if all the management of the bank is party to the arrangement. The initial preventive measure therefore is to require high professional standards for bank managements. A similar problem arises when junior management conceals a known relationship from senior management and internal auditors. The remedy here is to ensure that banks' internal controls function adequately with a clear decision-making procedure to ensure that isolated units do not escape the overall supervision of central management. Internal audit has an important function here. Equally important, external auditors and supervisors, using, as appropriate, bank examination or inspection techniques, can often play a vital role in detecting exposures of this nature.

Footnotes

4. In this paper the term "related" refers to relationships between borrowers. The term "connected", which is sometimes used with the same meaning, is used here to refer to counterparties connected in some way to the lending bank or its officers.

5. This recommendation was subsequently replaced by a Directive. The definition of a group of related clients was similar but not identical to the text reproduced here.