Supervising counterparty credit risk – a European perspective

Keynote speech by Elizabeth McCaul, Member of the Supervisory Board of the ECB, at the industry outreach conference on counterparty credit risk management, organised by the Federal Reserve Bank of New York in collaboration with the Basel Committee on Banking Supervision

New York, 28 February 2024

Introduction

I am honoured to be taking part in today’s conference on counterparty credit risk (CCR) management. It is a valuable opportunity to share best practices and bring together representatives from the banking industry, the supervisory community and the broader economy.

In my remarks, I would first like to clarify why I consider sound CCR management to be so critically important at the current juncture. And I very much welcome the chance to highlight a few concerns and inspire some critical thinking at this CCR outreach event.

Second, I would like to explain the ECB’s approach to supervising CCR, drawing on the report on sound practices in CCR governance and management that we published last autumn.

And third, I would like to provide a brief update on what we have seen in the European banking sector since publishing our report.

The importance of sound CCR management

Much has been written and said about the exponential growth of the non-bank financial institution (NBFI) sector and the shift in lending from the traditional banking sector to other market participants.

Since the global financial crisis, the NBFI sector in the euro area has doubled in size, from €15 trillion in 2008 to €32 trillion today. It now accounts for half of the financial sector, although the size of the global NBFI sector has recently decreased slightly against a backdrop of higher interest rates and lower asset valuations.^[1]

We have seen significant increases globally for some asset classes such as private equity, where assets under management have grown from around USD 3 trillion in 2012 to around USD 8 trillion today. We have also seen substantial global growth in private credit funds, which now stand at more than USD 1.5 trillion. The European private credit market, while considerably smaller than the US market, has grown by 79% over the past five years.^[2] At the end of 2022, the private credit market accounted for about USD 221 billion, or 15% of the global market. These numbers matter and are the reason why we are taking a closer look at the combined growth in the private equity and private credit markets.

The opacity of these markets, however, makes it hard to gauge the inherent risks. More worryingly, we have only a limited line of sight into potential indirect links between banks and non-banks and between non-banks and other non-banks, such as the correlation to common concentrations of exposures.^[3] Banks and non-banks are interconnected in many different forms through loans, securities, derivatives and funding relationships, so this could become a source of systemic risk.

The rationale for ensuring that we fully understand risks emanating from the nexus between market risk and credit risk is not new. As New York Superintendent of Banks, I lived through the days of the default of Long-Term Capital Management (LTCM), when we learned our lessons the hard way: not only how these risks can become intertwined and amplify each other in times of stress, but also how financial stress in a highly leveraged NBFI can spill over to the banking sector.

LTCM taught us to be wary of how credit risk and market risk transformation can occur and alerted us to a new risk: correlation risk. Recent events have underscored the need for us to understand both of these issues better. The defaults of Archegos Capital Management and Greensill Capital have highlighted some of the risks stemming from the increasingly complex interconnections between banks and NBFIs. And in the United Kingdom, pension funds and investment funds using liability-driven investment strategies exposed to leveraged derivative products forced the Bank of England to contain market dislocation in the gilt market.

While not the topic of today’s conference, I believe there is great merit in taking an internationally coordinated approach to strengthening the regulatory and reporting framework for non-banks that present potential risks to the banking sector and in bringing greater transparency to the NBFI sector.

Banks also have a primary role to play in improving our collective line of sight, for example by strengthening their own internal risk management frameworks and data aggregation capabilities for exposures to NBFIs. This brings me to the main topic of today’s conference: counterparty credit risk.

In short, if we are to fully understand the emerging risks and ultimately ensure that market participants are able to address them, sound practices for managing counterparty credit risk should go beyond minimum compliance with regulatory requirements.

The ECB’s approach to supervising CCR

Over the past few years, we observed that the search for yield in a low interest rate environment had incentivised some banks to turn to riskier and less transparent counterparties from the NBFI sector, including hedge funds and family offices.

When certain hedge funds ran into difficulty following the outbreak of the pandemic in 2020, we ordered some banks to improve their risk management in this area. And following the collapse of the family office Archegos in March 2021, we reviewed the risk management practices of a sample of banks that were particularly active in providing prime brokerage services. Based on these thematic reviews, we issued supervisory expectations on prime brokerage.^[4]

In 2022 we identified CCR as a broader supervisory priority and we have since taken a range of supervisory actions.

Under this priority, we performed a targeted review of CCR for a larger group of banks, which confirmed that some progress has already been made by certain banks and identified several good industry practices. But it also identified areas where only a few banks have adopted sound practices and where further efforts are needed to address several material shortcomings.

First, customer due diligence procedures for NBFIs should be improved and, if they cannot provide sufficient certainty, the client should not be onboarded.

Second, early warning indicators specific to derivatives and securities financing transactions, such as discipline in collateral payments, are not always considered when compiling watchlists, and some banks, potentially driven by competition, deviate from sound margin practices.

Third, banks with material or complex CCR exposures should explicitly specify their willingness to accept this risk in their risk appetite statement, rather than capturing it implicitly in credit risk, as CCR may be more complex than general credit risk. The potential transformation of risk from credit risk to market or liquidity risk is a case in point.

These findings were corroborated by the on-site inspections we conducted at specific banks to monitor the remedial actions being taken to improve CCR governance and management frameworks.

We published the final version of our report on sound practices in CCR governance and management in October 2023.^[5] This followed a public consultation in which we received very useful feedback from the industry. The consultation, which included a conference on CCR in June 2023, underscored the value of outreach events like the one today.

The report describes 43 sound practices, grouped into four categories: (i) CCR governance; (ii) risk control, management and measurement; (iii) stress testing and wrong-way risk; and (iv) the watchlist and default management process.

We expect banks’ approaches to be proportionate to the scale and complexity of their business, the products they offer and the nature of their counterparties. Banks should remediate shortcomings without undue delay and, given the uncertain geopolitical situation, avoid complacency.

We have placed considerable emphasis on CCR to date and will continue to do so.

Our initiatives do not focus solely on managing risks from exposures to the largest prime brokers or select counterparties, such as hedge funds, private equity or private credit funds. They focus on identifying relevant risks for all banks exposed to the broad range of ever-changing counterparty credit risks and how those risks may materialise, especially considering the potential for risk transformation or hidden correlation risk. We have reason to believe that certain NBFIs have been taking risks that make them more vulnerable to market shocks and, therefore, merit greater scrutiny.

In this context, I would mention the important joint work being done by the Federal Reserve Board, the Bank of England and the ECB to collect and exchange information on the banking system’s exposure to NBFIs. I would also like to highlight our work with the Financial Stability Board to identify and monitor risks from NBFI leverage from a holistic perspective, given the interconnectedness of these counterparties.

Working together to overcome hurdles is crucial to obtaining a clearer picture of the full spectrum of risks stemming from NBFIs.

What we see in the market

Overall, from the many off-site and on-site supervisory activities we have undertaken over the last two years, we see that banks are generally moving towards the sound practices published last October.

As part of the follow-up work to the targeted review, all of the banks scrutinised by the ECB planned remedial actions, with deadlines ranging from the third quarter of 2023 to the end of 2025. By the end of 2023, roughly one-third of these corrective actions had been implemented. This is good news.

However, some banks have major deficiencies and are not conducting appropriate remediation. And in general there are still a few major areas where banks need to step up their efforts.

The first is stress testing, especially for high-risk clients vulnerable to tail risk events and potential close-out risk. Generally, banks have developed stress tests on key CCR risk indicators and have implemented a CCR risk appetite indicator, but these are not always properly documented, reported or quantified. And sometimes they are disconnected from a well-functioning operational limit framework. An agile approach is needed here to ensure that stress testing carried out by the so-called 1.5 line of defence function complements the work of the second line. Banks need to invest in IT, adapt their approaches to bespoke stress testing and dedicate sufficient time to conducting these tests.

In addition, improved risk metrics are needed to capture illiquid, concentrated positions and the costs of winding down portfolios, among other things. Metrics need to be enhanced to address methodological shortcomings, as deficiencies can lead to risk being underestimated (through, for example, missing simulations of material risk factors or initial margin or missing wrong-way risk). These metrics need to be developed, since industry standard metrics, such as potential future exposure, are not always an adequate measure of risk for certain complex products like total return swaps.

Finally, some banks still need to set up regular fire drills to test their preparedness for dealing with a real counterparty default event. These need to feature a clear governance structure for the management of collateral and related risks.

The ECB is closely monitoring banks’ progress through off-site and on-site supervisory activities. And we have made the remediation of shortcomings in credit risk and counterparty credit risk management frameworks a supervisory priority for 2024-26.^[6] This means we will continue to implement specific supervisory work programmes on this priority.

Conclusion

Let me conclude.

We cannot rule out the risk that we will experience acute credit events or market dislocations affecting hedge funds, other NBFIs, or highly leveraged counterparties more generally, that may present contagion risks or correlation risks for the wider banking system. Therefore, we need to be as prepared as possible for such events by continuing to be an intrusive microprudential supervisor in this arena and making sure that banks can identify and assess these risks in a timely manner. We have made significant efforts to gain a deeper understanding of the sound industry practices for the governance and management of CCR. We are also committed to transparency – we are sharing the insights gained from our supervisory activities on the sound practices that help to manage and mitigate risk and we are developing guidance and standards. It is now crucial that banks continue to converge towards those standards and embrace the insights on sound practices. These steps are aimed at making a difference squarely within our banking supervision mandate.

But I cannot leave it there. Clearly, the lack of a full picture of how risk transformation may be occurring and correlation risks may be developing outside of our supervisory remit, in NBFIs, means that market discussions about a broader regulatory framework are worthy ones. Meanwhile, supervisors and the banking industry must continue to seek new ways to exchange information that is crucial for assessing the build-up of risks and the interconnectedness of different financial markets.

At the ECB, we stand ready to play our part in contributing to the broader micro- and macroprudential discussions with our colleagues at the Federal Reserve, the Bank of England and the broader Financial Stability Board community about improving the global regulatory framework for the complex, growing risks in this arena.

Thank you for your kind attention.