The role of banks in mitigating systemic risks arising in the non-bank financial sector

Speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the ECB conference on Counterparty Credit Risk

Frankfurt am Main, 20 June 2023

Good morning and welcome to the ECB conference on counterparty credit risk.

The central banking and supervisory community has been warning for years about systemic risks building up in the non-bank financial sector. And for good reason: elevated leverage and aggressive maturity and liquidity transformation at non-bank financial institutions (NBFIs) can be, and have been, a source of financial instability – especially in cases of inadequate risk management or limited regulatory and supervisory scrutiny.

The present environment of rapid monetary policy normalisation and heightened geopolitical uncertainty makes it more likely for such risks, potentially lingering beneath the surface, to emerge and materialise.

Today I would like to discuss how risks propagate from the non-bank financial sector through the banking system to become systemic, and ultimately have detrimental effects on the real economy. I would like to suggest that banks can play an important role in mitigating systemic risk by investing more in the assessment and management of the risks of their non-bank counterparties. And I will argue that, notwithstanding important developments in regulation in recent years – and changes in the macrofinancial landscape – banks’ management of counterparty credit risk remains one of the most important means by which systemic risk can be mitigated.

It is through the regulated banks that a light can be shone into the more opaque world of the less-regulated financial sector. And while policy discussions on adjustments to the regulatory framework for NBFIs continue, in the meantime we need to increasingly rely on banks’ role as the watchtowers of the sector.

And mitigating such risk is also profoundly in banks’ own interest, as a matter of sound risk management and mitigation. Recent examples have shown just how devastating poor management of counterparty credit risk can be for banks.

Build-up of risk in the non-bank financial sector

The recent turbulence that we’ve seen in banking sectors in the United States and Switzerland are a powerful reminder that pockets of risk have built up in the financial system through years of low interest rates, abundant liquidity and compressed volatility.

Yet while these risks crystallised most recently in the banking sector, they have also been building up, perhaps even more profoundly, elsewhere in the financial sector.

NBFIs – comprising investment funds, insurance companies, pension funds and other financial intermediaries that, in many cases, face much lighter prudential regulation and supervision than banks do – play an increasingly important role in financing the real economy and in managing the savings of households and corporates. Within the euro area, the growth of the NBFI sector accelerated after the global financial crisis, doubling since 2008, from €15 trillion to €31 trillion.

The share of credit granted by NBFIs to euro area non-financial corporates increased from 15% in 2008 to 26% at the end of last year. Overall, the NBFI sector assets are now around 80% relative to the size of the banking sector.

These institutions bring an important intermediation role and value to financial markets and the real economy. But NBFIs can be a source of financial instability, as they often combine maturity mismatches, leverage, and optionality risks without the same degree of regulation that banks face. NBFI vulnerabilities appear to have been on the rise. My colleague ECB Vice-President Luis de Guindos highlighted in a recent speech three in particular.

First, strong growth in the non-bank financial sector has been accompanied by an increase in liquidity mismatches. This has resulted in liquidity demand becoming more procyclical.

Second, financial and synthetic leverage in some segments of the NBFI sector have grown significantly. This includes repos and margin borrowing in prime brokerage, synthetic leverage via derivatives and structured finance leverage in securitisation-type vehicles.

For example, synthetic leverage of hedge funds has increased significantly in recent years.^[1] Such leverage can amplify shocks and create spillover risks for banks.^[2] We saw an example of this with the implosion of family office Archegos Capital Management in late 2021.

And third, there is evidence of insufficient preparedness to meet large demand for liquidity, especially from margin calls.

As a result of increasing financial, especially synthetic, leverage and liquidity vulnerabilities, NBFIs are prone to the risk of sudden de-leveraging when asset prices suddenly change and become volatile.

The volatile combination of leverage and liquidity risk crystallised in the UK in September 2022, when investment funds using liability-driven investment strategies faced large collateral requests in repo transactions and margin calls in interest rate derivatives following fiscal policy announcements triggering a sharp rise in gilt yields. This led to forced-selling of gilts, creating a self-reinforcing spiral that required the Bank of England to intervene to safeguard financial stability.

Counterparty credit risk

So, the current conjuncture presents us with increasing risks from NBFIs. At the same time, banks have maintained their central role in financial markets as the main dealers, clearing agents and gateways for NBFI entities. From our perspective as supervisors, this leads to the question of how exposed the banking system is to risks coming from the NBFI sector, and how interconnectedness between banks and NBFIs might act as amplification channels for systemic risk.

Of course, the risks posed by NBFIs are not new.

The collapse of the hedge fund Long Term Capital Management as a result of high leverage and exposure to the 1998 Russian financial crisis provided an early lesson in the risks of NBFIs for financial stability. It showed how a financial stress in a highly leveraged NBFI can transmit directly to the large banks at the heart of the financial system.

After the LTCM crisis, the international supervisory community came to the conclusion that risks from NBFIs were best kept under control by strengthening counterparty credit risk management at banks.

The assumption was that a crisis at an NBFI could take up a systemic dimension only by contagion to the banking sector.

This view was reflected in the work of the Counterparty Risk Management Policy Group (CRMPG), which issued its first report in 1999 in response to the LTCM crisis. The Group considered that counterparty credit risk is one of the main variables in determining whether, and with what speed, financial disturbances become financial shocks. Such shocks can be particularly damaging when the evaporation of market liquidity is magnified by concentrated, crowded trades across financial institutions (banks and non-banks) that are not easily anticipated by individual institutions.

The Basel Committee then issued its “Principles for the Management of Credit Risk” in September 2000. In this publication, the Committee highlighted the need for a clear and detailed definition of a bank’s strategy and risk tolerance for counterparty credit risk arising from derivatives and securities financing transactions in the banking and trading books.

The Committee clarified that banks must receive sufficient information for a comprehensive assessment to be made of the true risk profile of a counterparty, including the counterparty’s capacity to repay based on historical trends and future projections under various scenarios. The absence of transparency should result in tighter credit terms by individual banks.

These Basel principles remain an important benchmark of sound practices on counterparty credit risk, that banks should continue to pay heed to.

Improved regulation

But we should recognise that both the nature of the risks connecting banks to NBFIs, and the regulatory landscape in which those interactions take place have changed considerably since the LTCM fiasco.

The good news is that improvement in practices and regulation in terms of margining and the use of central counterparties (CCPs) have made the connections less systemic than in the past. The push to use clearing houses to act as circuit breakers means a CCP acts as a hub-and-spoke model, intermediating between many counterparties. And CCPs play a crucial role in increasing market transparency.

The European Market Infrastructure Regulation (EMIR) requires mandatory clearing of most trades. The increasing quantity of derivatives that are centrally cleared has simplified a complex picture of bilateral counterparty exposures. And there are margining obligations for big institutions and corporates.

Prudential rules are also more conservative and now disincentivise the businesses that are not centrally cleared and subject to margin. This sets incentives that go in the right direction.

And yet, some risks have changed their form, without disappearing altogether. Higher frequency margining, such as with clearing houses, also means that shocks on market risk factors and asset prices are transformed into liquidity shocks. These shocks then affect NBFIs and other non-financial counterparties, and can become an issue for the banking system – either directly through the default of the affected counterparties, or indirectly because counterparties need to sell assets that affect markets to which banks are also exposed, such as via increased volatility and reduced market liquidity. Such dynamics affect the values at which collateral can be realised by banks when closing out a counterparty or the market valuations of banks’ correlated trading portfolios.

Indeed, there remain multiple linkages which enable financial stress to be transmitted from the NBFI sector to the banks.^[3] Banks are directly connected to the NBFI sector entities via loans, securities and derivatives exposures, as well as through funding dependencies. Funding from NBFI entities is possibly one of the most significant spillover channels from a systemic risk perspective, given that NBFI entities maintain their liquidity buffers primarily as deposits in banks and interact in the repo markets with banks.

And as highlighted by the ECB’s recent Financial Stability Review, links with NBFI entities tend to be highly concentrated in a small group of systemically important banks, whose sizeable capital and liquidity buffers are essential to mitigate spillover risks.

Episodes of distress

In the last 15 years we have witnessed episodes of distress at NBFIs take on new forms.

Some episodes have taken on a systemic relevance of their own.

The recent UK experience with liability driven investment schemes and contagion via the gilts market is one example. Another was the failure of AIG in 2008, where the widespread effects of large losses on its OTC structured finance and credit derivatives positions would have exposed its counterparties to substantial losses if the government had not stepped in.

Others, like Archegos, revealed ineffectiveness of risk management and internal controls at banks, enabling NBFIs to take up excessively leveraged and concentrated positions. Credit Suisse’s losses linked to Archegos totalled $5.5 billion, a sum which underscores banks’ self-interest in getting counterparty credit risk right. Not only was this loss substantial by itself but it was a contributing factor to the ultimate downfall of the bank, leading to its government-orchestrated acquisition by UBS.

Trigger events can be financial, such as central banks embarking in fast monetary policy tightening cycles to fight inflation as it has been for several months now. But also nonfinancial events, such as the fiscal policy announcements in the UK, can have strong impact on NBFIs, which can propagate through the financial sector and directly to the economy, with the potential to generate systemic disruptions.

International policy initiatives

Given the role that NBFIs have taken in the financing of the economy, and the potential for systemic risk stemming from their exposure to liquidity risk and their role in building up leverage, a debate has started at international level on extending the regulatory coverage of their activities.

The concern is that as segments of the NBFI sector have remained largely unregulated, or subject only to transparency and conduct of business requirements, risks have been allowed to grow largely unchecked and structural vulnerabilities may have bult up outside the scrutiny of supervisory authorities.
The Financial Stability Board (FSB) has set out a number of policy proposals to address systemic risk in NBFIs^[4] focusing on those activities and types of entities that may particularly contribute to aggregate liquidity imbalances and the transmission and amplification of shocks. National financial authorities and international standard setting bodies should seriously consider these proposals.

But we know that international policy discussions take time.

And it takes even longer before these discussions translate into applicable rules in the EU. We’re talking years, and that’s being optimistic.

Meanwhile, the risks from leverage in the NBFI sector are present right now. As we’ve seen from the recent cases, things can blow up very quickly.

Sound practices on counterparty credit risk

So, in terms of the tools that are available to us right now to mitigate these risks, I believe that effective counterparty credit risk management by banks remains the most important safeguard.

That’s why counterparty credit risk management has been such an important focus for ECB Banking Supervision in the current environment. Exposures to counterparty credit risk, especially towards non-bank financial institutions, is one of the key vulnerabilities identified in the ECB’s supervisory priorities for the 2022-2024 period.

After the Archegos default and the related post-mortem analyses conducted by a number of international supervisors, the ECB performed a review of prime brokerage on a sample of SSM supervised entities. This exercise enabled us to identify good and bad practices in the areas of client onboarding and due diligence, risk management, margining and default management processes. We developed supervisory standards on prime brokerage and communicated them to a number of selected banks particularly active in this line of business.
In August 2022, we published a newsletter outlining our supervisory expectations for prime brokerage services.

At the end of 2022, we finalised a horizontal review focused more broadly on governance and risk management of counterparty credit risk across based on a wider sample of banks active in derivatives and securities financing transactions.

In a blog post published in January 2023, I highlighted areas where institutions have more room for improvement, to align with observed good practices, both at onboarding and on an ongoing basis.

I also pointed out the need to develop appropriate stress testing capabilities for counterparty credit risk as a particularly important safeguard against the build up of excessive counterparty credit risk concentrations in the system. Such stress tests are critical for banks to understand where they could face concentrated exposures to vulnerable counterparties and to mitigate such exposures in advance of a potential market disruption.

The key message is that we expect institutions 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 nature of the counterparties.

Conclusion

Risks in the NBFI sector could intensify in coming months as monetary policy continues its effort to bring inflation back to its target. As a banking supervisor, we have taken action to promote good practices in banks’ counterparty credit risk at different levels. This includes the targeted review, but also day-to-day monitoring by our supervision teams.

And a conference like today’s, bringing together in the same room a significant proportion of the key individuals that are involved in managing counterparty risk, that have the expertise and the responsibility for this area, is another way for us to help. By putting emphasis, reminding people that this is important, fostering networking connections, exchanges of views, and cross fertilisation we hope to promote thought leadership in counterparty credit risk to benefit financial stability.

Banks remain at the heart of the system as dealers, despite NBFIs taking on roles like credit intermediation and providing liquidity in markets. Banks need to manage effectively their counterparty credit risks more than ever – both to protect their own resilience and to ensure the stability of the financial system as a whole.

Thank you very much for your attention.