13 January 2023

Blog post by Andrea Enria, Chair of the Supervisory Board of the ECB: Tackling counterparty credit risk

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.

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.

SSM

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