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Supervisory expectations for prime brokerage services

17 August 2022

Bank losses linked to the default of US family office Archegos Capital Management at the end of March 2021 totalled over $10 billion. This incident highlighted the increasingly complex interconnections between banks and non-bank financial institutions, confirming that sound risk management, governance and culture are key for addressing the tail risks stemming from the prime brokerage business.

Although Archegos’ collapse did not have a negative impact on banks under European banking supervision, the ECB has actively participated in the international initiatives launched in its wake, also to draw more general lessons. These included the international supervisory community’s post-mortem analysis, as well as contributions to the supervisory and regulatory debate of the Basel Committee and the Financial Stability Board.

In order to gain better insight into the status of this business area for the banks under its supervision, the ECB has also performed a targeted analysis of the risk governance and risk management frameworks associated with prime brokerage services, focusing on a subsample of relevant banks.

This desk review analysis has shaped detailed supervisory expectations in the areas of i) client onboarding, ii) risk management, iii) margining and iv) the default management process. The ultimate objective of these expectations is to ensure that banks have sound risk management, strong governance and a proper risk culture for their prime brokerage businesses. These are after all the main safeguards to help financial institutions manage risks stemming from a business characterised by high competition, which can lead to excessive risk-taking, and a lack of transparency about clients’ investment strategy and counterparties’ portfolio composition.

In terms of client onboarding, the ECB expects banks to have an adequate, comprehensive, and well-documented credit assessment process in place, covering all the relevant financial and non-financial aspects of the client relationship. The outcome of the credit assessment process should not only be a key element in the onboarding decision, but should also underpin important contractual provisions, such as determining limits, margining caveats, collateral arrangements, credit tiering or reporting requirements. An effective know-your-customer (KYC) process should also be part of the credit assessment, and should be performed on an ongoing basis, making use of all available information (public and non-public) to minimise the risk of dealing with high-risk individuals. A client’s failure to provide information should result in a more conservative approach to collateral, margining and limits or, in justifiable cases, trigger client offboarding.

As for risk management, the ECB expects banks offering prime brokerage services to have a sound and robust risk governance: executive management should be adequately involved in decision-making and be able to rely on a comprehensive overview of all associated risks. Prime brokers should have a documented and clear risk strategy in place, defining their risk appetite in addition to an adequate and effective credit risk management process, tailored to the clients they serve and the services they offer. The risk appetite framework should clearly transpose the bank’s appetite towards all risks involved in providing prime brokerage services to different types of clients and should set clear limits. Banks should be able to promptly identify and effectively monitor all material exposures to risks related to the brokerage business. Adequate reporting should allow executive management to understand the risks stemming from this activity and the potential vulnerabilities of the business model franchise.

One important lesson learned from the Archegos default was that banks are overly reliant on one-dimensional risk measures in their monitoring and limit frameworks (often, they just use potential future exposure). Banks should therefore implement comprehensive suites of stress tests or scenario analysis tools to address this issue.

The ECB expects banks to implement initial margin concepts properly, reflecting multiple facets of the risks to which the bank is exposed through the brokerage relations. Initial margin models should reflect the composition of margined clients’ portfolios, concentration and market liquidity risks to which the funds are exposed as well as funds’ investment strategies. Banks are expected to implement models that dynamically adjust the level of the margin to the changes in the risk profile of the transactions.

Default management processes should consider all material contractual arrangements with respect to default and close-out provisions, and banks should conduct an ongoing assessment of the efficiency of liquidation strategies and capabilities at hand.

Supervisors have also performed a preliminary analysis of minimum capital requirements for prime brokerage services. The ECB expects banks to properly consider the riskiness of this business area in their internal capital adequacy assessment process. The quantification of the own funds for prime brokerage should address all sources of material risk and reflect periods of severe market disruptions.

The ECB stresses that the abovementioned supervisory expectations are not replacing existing principles on risk governance and risk management. These supervisory expectations have been shared with banks covered by the desk review and other relevant banks. Follow-up work will be done in the context of the targeted review on counterparty credit risk and also as part of upcoming on-site inspections.


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