As the global environment changes its trajectory, with interest rates normalizing to higher levels and the presence of geopolitical uncertainty such as the conflict in Ukraine, NBFIs present themselves to banks as a source of financial instability.
On 2 June 2023, the European Central Bank (ECB) invited banks and practitioners to provide comments on counterparty credit risk sound practices, with the consultation period ending last 14 July 2023. A total of 43 good practices were identified in the report, which were based on the results of the targeted review performed in the second half of 2022 on how banks govern and manage counterparty credit risk. All 43 good practices identified by the ECB are predicated on the expectation for institutions to go beyond mere compliance with regulatory minimum requirements when designing their risk management and control approaches to counterparty credit risk.
The practices in this article apply to banks which are subject to counterparty credit risk through the offering of capital market services to high risk counterparties as well as other areas of exposures. The practices outlined here will help to form the approach taken toward CCR by banks to manage and control counterparty credit risk. Improvements in areas such as defining the risk appetite, default management process and stress testing are identified in the report. The ECB will be publishing comments received as well as the final version of this report
List of Good Practices Described in the ECB Report
As institutions are already beset with a myriad of regulatory considerations, counterparty credit risk being just one of them, we have identified three specific points, that institutions may consider putting at the forefront of their agenda in implementing good practices on their counterparty credit risk framework. We have selected one practice from each of the categories above, with exception to Risk Control, Management and Measurement, which we believe is an area which requires the least amount of change, when compared to other categories, for affected institutions and hence, will not be covered in this article.
Establish a Dedicated and Comprehensive Governance Framework over Counterparty Credit Risk
Counterparty credit risk is a multidimensional form of risk, driven by counterparty exposure level (i.e. market risk factors) and credit quality (i.e. credit risk factors). As such, a number of institutions have designed the framework over counterparty credit risk based on cross-function collaborations among Treasury and Asset and Liability Management, Corporate and Investment Banking and Global Financial Markets in the first line of defence (1LOD) and between market and credit risk departments in the second line of defence (2LOD).
Counterparty credit risk is an umbrella risk to the institution and cannot be monitored and managed within a suite of other risks monitored by the existing risk management framework. This risk should be identified as a separate component despite the link in combination of market and credit risk. The unique nature of the risk requires a dedicated process in place across the requisite lines of defence to address this risk.
However, there have been instances where these departments have been working in silos, with no specific function having a comprehensive view and ownership over counterparty credit risk. It may also be the case where counterparty credit risk does not even have its own set risk appetite and board committee and would be embedded within the overall credit risk framework.
Institutions should establish a dedicated, comprehensive governance and risk management framework to deal with increased counterparty credit risk exposures, together with a well-defined three lines of defence model with proper delineation of responsibilities and clear reporting lines. These functions should have adequate coverage over all relevant sources of counterparty credit risk exposures. Institutions should also consider supplementing their framework with specific counterparty credit risk governance committees that have direct responsibility and visibility over the institution’s overall counterparty credit risk exposure.
Capture Wrong Way Risk in Stress Testing
The collapse of Archegos Capital Management in 2021 exposed a number of banks, including Credit Suisse, to substantial losses. Archegos was a limited partnership family office which managed the personal assets of New York Investor Bill Hwang. The positions held were highly concentrated within a group of companies (e.g. Viacom CBS) and in March 2021, Viacom CBS suffered a severe fall in share price. Total return swaps were used by Archegos to cover this exposure, however they were unable to meet margin calls made on these swaps by some of the banks through which the positions were held. As such, this triggered a fire sale of the positions (i.e. stocks) held in these companies by the banks in question. The rapid decline of Archegos’ highly leveraged positions led to margin calls from multiple banks and brokers, ultimately resulted in the unwinding of the fund’s positions and the realization of wrong way risk. In this context, wrong way risk pertains to instances where the credit quality of the counterparty is negatively correlated with the counterparty’s credit exposure.
During normal market conditions, wrong way risk tends to be negligible which is probably a reason why a number of institutions end up neglecting its impact. However, when institutions do start seeing wrong way risk, it would usually be too late for the institution to do anything about it.
A number of institutions would look at initial margin, which is usually based on a standardized methodology, as a primary mitigant against stressed levels of counterparty credit risk. But upon closer investigation, these initial margin methodologies do not take wrong way risk into account and initial margin tends to be easily outweighed when such risk is realized.
Implementation of a Default Management Plan Governance
The implementation of risk management, by itself, does not guarantee the elimination of counterparty credit risk. Hence, institutions should be on their toes and be ready to proceed when a counterparty default does happen. The existence of a clear and well-defined default management plan complemented by the early identification of distressed counterparties in institutions’ “watchlist” are integral to sound and effective risk management of counterparty credit risk, allowing institutions to be more proactive in monitoring and managing their exposures to these higher-risk counterparties.
ECB recommends institutions to develop a default management policy governance to capture regulatory and ad hoc organizational structures organizing and executing close-out and restructuring cases, the preparatory steps ahead of a potential default event, consideration of proactive actions, mandatory and optional process steps and accurate data aggregation in a timely manner.
Depending on the institution’s assessment of its own counterparty credit risk framework, other identified good practices may need to be prioritized for implementation as well. Ultimately, institutions need to be strategic in their approach in developing a comprehensive counterparty credit risk framework that incorporates all good practices.
While there is no one optimal approach on the design of counterparty credit risk management and control, such an approach should be proportionate to the scale and complexity of the business, products offered, and the nature of the counterparties. More than ever, institutions to be prepared to keep abreast with the risks that are relevant for counterparty credit risk management in an increasingly fast-paced and complex market environment.
How Can We Help?
Grant Thornton has worked with some of the largest global financial institutions on counterparty credit risk implementation. We can draw on this insight of best practice to support smaller and mid-tier banks and Markets in Financial Instruments Directive (MiFID) firms to develop pragmatic approaches to counterparty credit, which are proportionate to their time and scale.
At Grant Thornton, we offer best in class advisory and assurance services to support your business adopt an optimal framework on counterparty credit risk. Our services are delivered by subject matter experts at the forefront of their field. They will work with you to ensure that your counterparty credit risk framework implementation complements your overall business strategy.
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