Colombia joins the Basel Evolution: Navigating Large Exposures

Colombia is stepping up its commitment to financial stability with its own tailored approach to Basel III. In February 2024, the Superintendencia Financiera de Colombia (SFC) rolled out External Circular 003, a bold move to cap the potential losses banks could suffer from sudden counterparty failures, while safeguarding their solvency. By adopting this proactive risk management posture, financial and credit institutions across Colombia are positioned to significantly reduce contagion risks, creating a more resilient and stable financial system for the entire country.

In response to the 2007-2008 financial crisis, the Basel Committee on Banking Supervision (BCBS) crafted a series of frameworks to bolster financial stability, with Basel III at the forefront. Known in some regions as the Fundamental Review of the Trading Book (FRTB), Basel III sets new, more rigorous standards for calculating market risk capital, pushing banks to adopt a more risk-sensitive approach.

The beauty of Basel III is its adaptability—jurisdictions can tailor its core principles to better fit local market dynamics. In Brazil, for instance, the default risk charge (DRC) methodology is the preferred approach. The European Banking Authority’s framework goes by CRR 3/CRD VI, while the U.K.’s Prudential Regulation Authority refers to its standards as Basel 3.1. In the U.S., the Basel III Endgame has introduced a DRC specifically for securitization exposures, underscoring how each region uniquely interprets and applies the global framework.

Latin America and the Caribbean are embracing large exposures (LEX) regulations, a crucial tool for managing credit risk concentration across the region's banking sectors. These regulations have two key objectives:

• Microprudential: To safeguard individual banks by acting as a safety net within the risk-based capital framework, protecting them from significant losses due to the default of a single counterparty or a tightly connected group.
• Macroprudential: To strengthen the financial system as a whole by reducing interconnections among systemically important banks, helping to curb systemic risks and create a more resilient banking landscape.

By implementing LEX, the region is not only fortifying its banks but also enhancing overall financial stability in Latin America and the Caribbean.

External Circular 003 For LEX

The SFC’s External Circular 003 introduces robust new requirements to enhance how financial and credit institutions manage risk concentration among clients, client groups, connected groups and third parties. By aligning exposure limits with tier-1 capital, these regulations aim to create a more resilient financial sector.

Key measures include:

• Exposure Limits: Defined in relation to each institution's capital and equity, these limits prevent excessive exposure to economic groups or related clients (Proforma 427), reducing the risk of overextension.
• Regulatory Reporting: To meet compliance standards, institutions are required to submit monthly and quarterly reports (Proforma 428) detailing exposures per counterparty, the guarantees to mitigate these risks (Proforma 429) and an updated catalog of connected counterparties (Proforma 433). This structured reporting strengthens the regulatory oversight of risk concentration.
• Transparency and Control: Enhanced disclosure requirements and internal controls enable institutions to actively monitor and manage their exposure risks.

Together, these provisions reinforce prudent loan portfolio management and strengthen overall financial stability.

Functional Drivers and Technical Challenges of LEX

Colombian institutions now face new and complex demands under the updated regulatory framework, requiring rigorous risk assessment and reporting. Key steps they must undertake include:

• Counterparty Identification: Institutions must pinpoint all counterparties that could pose large exposure risks, whether individually or within connected groups.
• Exposure Calculation: Both on- and off-balance sheet items from banking or trading books, as well as instruments with counterparty credit risk, must have their exposure value calculated. This exposure value can be reported as the accounting value or, alternatively, gross of specific provisions and value adjustments. For off-balance sheet items, credit-conversion factors transform these values into exposure equivalents.
• Risk-Mitigating Warranties: Institutions must assess eligible risk-mitigation measures by determining applicable warranties and identifying exposures linked to these warranties, using an adjustment factor that accounts for the warranty type and currency.
• Limit Determination: Exposure limits must be set for individual counterparties and connected groups, ensuring risk remains within regulated boundaries.
• Regulatory Reporting: Compliance with these new rules includes regular submission of detailed reports through designated proformas.

By meeting these rigorous standards, Colombian institutions are strengthening their resilience and aligning closely with global best practices for managing credit risk.

Regulatory Compliance and Business Opportunity

While LEX requirements present significant challenges for institutions, they also offer a unique opportunity to enhance risk management and boost transparency across the organization and the wider financial sector. With the right data management software and governance—ideally integrated into a single platform—institutions can not only comply with these complex regulations but also scale for future requirements and unlock powerful business intelligence.

A comprehensive solution should include the following capabilities for managing large exposures:

• Centralized Data Access: Financial institutions can easily extract exposure information per client from any system or report, consolidating it into one centralized location.
• Automated Processes: Streamlining the extract, transform and load (ETL) process minimizes the risk of manual errors and ensures timely compliance with regulatory deadlines.
• Data Lineage: Provides clear traceability from the data's origin to the final report generation, ensuring auditing and regulatory compliance are simple and transparent.
• Advanced Analytics: Powerful tools to proactively identify and manage LEX-related risks, helping institutions stay compliant and gain deeper insights into their risk profiles.

By adopting such a solution, Colombian financial and credit institutions can effectively eliminate large exposures, introduce rule-based identification and calculations and reduce their capital-eligible base—setting a strong foundation for ongoing success.