Inside out

One of the key requirements of the proposed Basel II accord is that banks must assess their exposure to credit risk on an institution-wide basis – the committee expresses the view that “risk concentrations are arguably the single most important cause of major problems in banks”. In assessing this exposure, banks are required to consider all possible exposures to a particular credit, including loan assets, liabilities, off-balance-sheet items, exposures arising through the execution or processing of transactions, or through a combination of exposures across these broad categories.

Because lending is the primary activity of most banks, lending exposures are often the most material risk concentrations within a bank, but there can be many other types of exposures.
Consequently, regulators require banks to have in place effective internal policies, systems and controls to identify, measure, monitor, and control their credit risk concentrations, and these policies are required to cover all of the different forms of credit risk to which a bank might be exposed.

The Financial Services Authority (FSA) has produced near-final rules in respect of these issues, which are expected to be brought into effect by 31 December 2004. These require that a firm should be able to measure individual credit exposures across its entire portfolio and that it has a system in place that provides timely and accurate credit risk reports on these exposures.

Lending banks perceive themselves as having a closer and more intimate relationship with borrowers than that which exists between bondholder and issuer. As a result, a lending bank will generally impose upon the borrower obligations to provide information that are greater than the obligations placed upon an issuer of debt securities, either by listing rules or by the general law. Such obligations might require the borrower to provide some degree of advanced warning of credit and other problems. A borrower might, while all is going well, restrict the flow of information to lenders to that which is already publicly available. However, when problems arise, it is one of the advantages of raising money in the loan market that the borrower can sit down with a small number of banks at an early stage and discuss problems, solutions and possibly restructuring.

A necessary consequence of this sort of discussion is that the
lending arm of the bank will acquire confidential information about the borrower that is not available to the public markets. Ordinarily, this creates a solvable problem – the lending arm of the bank will be in possession of inside information as regards any securities that the customer may have in issue, but such information can and should be maintained behind a Chinese wall within the lending arm of the bank and can be ringfenced from the bank’s own securities dealers.

The problem is that for credit management purposes, it is now in effect a regulatory requirement that this information be used at the bank level. Credit analysis within a bank is usually performed by the bank’s credit analysts allocating an internal ‘rating’ as regards each customer to which the bank might have a credit exposure. These ratings will be used for a variety of purposes within the bank, but the most important of these for this purpose is the determination of overall credit limits at an institutional level. This allocation is likely to be made by a credit committee charged with the task of establishing credit limits for the bank’s total exposure to any particular counterparty at an institution-wide level. In general, a credit committee is not restricted in its access to information and one would not expect to find Chinese walls between a credit committee and credit analysts.

The management of credit exposures might be conducted by raising
or lowering credit limits. Where a credit limit is lowered to a level below that of the current institutional exposure, this constitutes an instruction to reduce exposures, and might be implemented in a number of ways – sub-participation of loans, sale of bond holdings, purchase of credit protection in the credit default swaps (CDS) market – some of which are within the insider dealing regime. More generally, even where a bank’s current exposures are below the revised credit limit, a downwards revision of a credit limit may have the effect of encouraging the bank’s securities traders to dispose of relevant securities. In either of these cases, the actions of the analyst or of the credit committee could constitute insider dealing.

In the UK, the use of confidential information within a bank is controlled by the market abuse regime and the insider dealing regime. The market abuse regime is unlikely to apply, as it catches only transactions that affect securities traded on UK markets, and debt securities are almost never traded on market. The insider dealing regime, however – Part V of the Criminal Justice Act 1993 (CJA) – applies to the activities of individuals in the UK who deal on a wide variety of markets, either in instruments directly traded on those markets or in derivatives priced off instruments traded on those markets.

The CJA states that an individual who has information about an issuer of securities from an inside source – loosely, from a director or other officer of the relevant company – is guilty of the criminal offence of insider dealing. This is when they deal in, or encourage someone else to deal in, securities on a regulated market, where those securities are ‘price-affected securities’ – where the information, if made public, would be likely to have a significant effect on the price of the securities. ‘Dealing in securities’ includes procuring, directly or indirectly, the acquisition or disposal of securities by others. Information is inside information if it is non-public, is specific or precise and relates to particular securities or to a particular issuer or issuers.

The term ‘securities’ is extraordinarily widely defined in the CJA, and the cautious view is that it includes not only transactions in listed securities, but also in any CDS a bank enters into, regardless of whether the bank is the protection buyer or the protection seller, or of whether the CDS is cash or physically settled.

This offence is only committed if the person concerned knows or has reasonable cause to believe that what they are doing will result in a dealing taking place. Where an analyst changes an internal credit rating or a credit committee reduces a credit limit, it is unlikely that this action could be construed as a deliberate encouragement to the bank to deal, as the question of whether a dealing will happen will be a function of a large number of factors of which the change in rating will be only one. However, the greater the change in the rating or the credit limit, the more likely it must be to the analyst or the credit committee that dealing may result.

It should be noted that it is a defence to insider dealing for the defendant to prove that they would have done what they did even if they did not have the relevant information. Accordingly, if there is a policy that is already in place which prescribes a set response to particular triggers, that may be helpful. This doctrine is also of use where a bank acquires confidential information after it has bought credit protection. If the bank can prove that it would have exercised its rights to trigger the CDS in any event, the fact that it might have other relevant information at the time it enters into the transaction will not be relevant because of this defence.

The Basel II requirements, as and when implemented, will not override the market abuse and insider dealing restrictions. Compliance with Basel II is not a safe harbour for these purposes. All credit risk management activities will need to be carried out in compliance with both the requirements of Basel II and with the insider dealing and market abuse regimes. Accordingly, the Basel II requirements will amount to an overlay on the compliance requirements in respect of insider dealing/market abuse. Designing bank credit management systems to address these issues might be the major challenge for UK bank management this year.

Simon Gleeson is a partner in Allen & Overy’s financial services group