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Andrea Enria
Chair of the Supervisory Board of the ECB

Tackling counterparty credit risk

Blog post by Andrea Enria, Chair of the Supervisory Board of the ECB

Frankfurt am Main, 13 January 2023

In 2021 we raised early concerns about financial risks building up in the banking system. We observed that the search for yield in a low interest rate environment had incentivised some banks to increase the volume of capital market services provided to riskier and less transparent counterparties, including non-bank financial institutions (NBFIs), such as hedge funds and family offices. We therefore identified exposure to counterparty credit risk (CCR) as a supervisory priority for 2022 and initiated a range of supervisory actions.

In the aftermath of the collapse of the family office Archegos, and like other supervisors of major jurisdictions, the ECB reviewed the risk management practices of a sample of banks particularly active in providing prime brokerage services, a specific capital markets activity with a high degree of CCR exposure. In August 2022 we published our supervisory expectations in this area.

Later in 2022 we conducted a targeted horizontal review of governance and high-level risk management of CCR at 23 banks active in derivatives and securities financing transactions with non-banking counterparties. Owing to the volatility of energy and commodity prices brought about by Russia’s war in Ukraine, we included − in addition to NBFIs − non-financial counterparties such as commodity traders and energy utilities. This gave us the opportunity to also see how the banks in the sample that were particularly active on capital markets were meeting our aforementioned expectations on risk management in prime brokerage services.

We observed some progress in how institutions measure and manage CCR. The review identified a number of good industry practices, but also several material shortcomings compared with supervisory expectations. As a general remark, institutions need to go beyond mere compliance with regulatory requirements when designing their approaches, which should be proportionate to the scale and complexity of the business, products offered and the nature of the counterparties, as well as the need to keep pace with the increasingly fast moving and complex market situation.

First, client due diligence procedures, both at onboarding and on an ongoing basis, should be reinforced when dealing with non-banking counterparties and have a substantial impact on credit decisions and contractual conditions. The second line of defence should play an active role here, and a client’s failure to provide information should result in a more conservative approach to collateral, margining and limits, or even rejection or offboarding of clients. By the same token, the first and second lines of defence should monitor these counterparties to ensure they have sufficient shock-absorbing capacity and adequate policies, procedures and controls in place.

Second, banks with material or complex CCR exposures should specify their willingness to accept this risk in their risk appetite statement, rather than capturing it implicitly in credit risk. The reason for this is that, compared with general credit risk, CCR might present additional complexities, such as illiquid collateral and hard-to-replace transactions, and banks should consider these when setting risk appetite and limits. To this end, banks need a broad set of risk metrics encompassing all facets of CCR.

Third, banks need to step up their efforts to develop – consistently across all business lines – appropriate stress testing capabilities for CCR, and to ensure that the internal stress test results have an impact on risk monitoring and limits, with a particular focus on NBFIs. The scenarios in the stress testing framework for CCR should address not only counterparties’ creditworthiness, but also their vulnerability to bespoke exposure tail events, where such vulnerabilities can be magnified by combinations of high leverage, maturity mismatch, and non-linearities due to exposure to crowded trades. This means, above all, conducting more frequent stress tests to reflect a rapidly shifting risk environment. Moreover, the framework should aim to identify counterparties whose solvency or liquidity position might come under pressure in certain market scenarios, and to detect concentration in exposure to margin shocks, a significant build-up in credit exposures, or vulnerabilities to rapid deleveraging. We have often noticed that banks rely considerably on the knowledge of their business lines, while not sufficiently using that knowledge for risk metrics, concrete limits, escalation to senior and top management and reduction of business. A sound CCR management framework and related stress testing should also address generic and specific wrong-way risk, i.e. the risk arising when the exposure to a counterparty increases with the risk of the counterparty’s default. Some minimum requirements for the identification, reporting and follow-up of wrong-way risk are set out in regulation, and banks should be ready to develop more sophisticated approaches if the nature of their business so requires.

Finally, there is still room for improvement in how, on a firm-wide basis, CCR is mitigated, monitored and managed when a counterparty is in trouble or defaults, especially in the case of over-the-counter non-cleared derivatives. In many cases, static margins have not yet been replaced with more risk-sensitive arrangements. Sometimes, legal terms even appeared to have been relaxed under commercial pressure. Early warning indicators specific to derivative and security financing transactions, such as discipline in collateral payments, are not always considered when compiling watchlists. Not all banks are testing the operational effectiveness of close-out procedures with regular “fire drills”. The management body and risk committee should be informed without delay of market tensions, major margin disputes, counterparties in difficulty and near misses observed by treasury and collateral management departments.

Regardless of when and how the next market crisis arises, and of the transmission channels through which it will spread to the banking sector, banks should be well prepared and manage their counterparty credit risk at an acceptable level, especially when dealing with the growing NBFI sector. This year we will follow up on the outcome of the review with off-site work and, in some cases, on-site inspections. We will use the full spectrum of supervisory tools to ensure that supervised banks promptly address weaknesses in their risk management frameworks.