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The European Central Bank has released a final report of its targeted review into how banks manage counterparty credit risk.
This review, conducted during the second half of 2022, was based on a horizontal review of governance and risk management for counterparty credit risk at 23 organisations that were significantly involved in trading derivatives and securities financing transactions with non-bank counterparties.
The findings of this study are summarised in its final report, Sound Practices in Counterparty Credit Risk Governance and Management, which was circulated to the market for public consultation which ran until July 2023.
Following the collapse of Archegos Capital Management, the ECB also took the decision to review risk management practices at a sample group of banks that were active in delivering prime brokerage services and, in August 2022, it published its supervisory expectations for prime broker services.
The Sound Practices in CCR document reiterates the ECB’s view that in meeting the requirements of the EU regulatory framework, and other relevant regulatory frameworks, institutions must go beyond “mere compliance” with regulatory minimum requirements when constructing their risk management and control procedures for managing counterparty credit risk (CCR). These approaches must be proportionate to the scale and complexity of the firm’s business, the products that it offers and the types of counterparties that it does business with.
While stress testing offers one important mechanism for evaluating the potential risks associated with each individual client, firms can also apply Pillar II models to capture the multiple factors contributing to CCR in the exposure calculation.
The report indicates that, at the reference data for the survey on 31 March 2022, the banks selected for this targeted review had approximately €1,245 billion in aggregate CCR exposure value, of which 59 per cent derived from derivatives products and 41 per cent from securities financing transactions (SFTs). At this point in time, they also had €278 billion of CCR risk-weighted exposure amount (RWEA), of which 82 per cent was linked to derivatives contracts and 18 per cent to SFTs.
The targeted review highlighted the progress that the ECB believes firms have made in managing CCR risk and adopting good industry practices. However, it identifies several “material shortcomings” that persist.
Specifically, it finds that customer due diligence procedures need to be improved when dealing with non-bank counterparties, both during the onboarding phase and on an ongoing basis. This includes taking a more conservative approach in setting credit terms for clients that fail to provide transparent information regarding whether they have adequate shock-absorbing capacity, procedures and controls in place.
The report advises that stress testing frameworks should address not only counterparty creditworthiness, but also vulnerability to specific tail events where their overall vulnerability can be accentuated by factors including high levels of leverage, maturity mismatches or risks resulting from exposure to crowded trades.
The framework should identify counterparties whose solvency or liquidity position is likely to come under pressure in certain market situations and should identify risk concentration in exposures to margin shocks or vulnerability to risk deleveraging.
The ECB paper finds that there is still room for improvement in how CCR is managed when a counterparty is in stress or defaults. In many cases, for example, it finds that static margins have not yet been replaced with more risk-sensitive arrangements, a concern that was prominent in ex-post analysis of the Archegos default.
Early warning indicators specific to derivatives and SFTs, such as discipline in margin payments, are not always considered when compiling watchlists, the report finds.
Many of the core issues highlighted in the ECB paper, and by the targeted review that informed this report, are longstanding elements of counterparty credit risk analysis and stress testing framework design that the industry has been discussing for many years.
It represents a valuable document in highlighting where practices are still falling short and providing high-level recommendations for remedial action. It is telling the industry to get better at doing what it knows it should be doing.
The point of departure, the report tells us, is that over the past 10 to 15 years, the low interest rate environment fostered search-for-yield strategies and incentivised some banks to increase the volume of capital market services that they provide to more risky and less-transparent counterparties, often non-banks, and “less regulated or unregulated entities such as hedge funds and family offices”. But ultimately the message is for banks to get the basics right when managing credit risk with bank and non-bank counterparties.
Credit Suisse’s candid and detailed internal dissection of its Archegos failings provides clear reminder of why this is important.
