ECB draws lessons from Archegos collapse in report on counterparty credit risk governance and management
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The collapse of Archegos in 2021 was a wake-up call for regulators as to banks' vulnerabilities to counterparty credit risk. In response, the ECB conducted a targeted review and published a report on sound practices in CCR governance and management. The report identifies best practices and highlights several areas where banks need to improve their CCR management, including senior management oversight and stress testing.
In this blog post, we summarise the key messages from the ECB report and explain how banks should enhance their CCR governance to meet supervisory expectations.
In the aftermath of the collapse of family office Archegos Capital Management in 2021, the ECB identified counterparty credit risk (“CCR”) as a key priority for 2022 in its supervisory priorities for the years 2022-2024. In the low-interest-rate environment of the past ten to 15 years, many banks increased their exposures to non-bank financial institutions (“NBFIs”) – including high-risk entities such as hedge funds and family offices.
While no ECB-supervised bank was caught up in the Archegos default, the ECB was quick to react and conducted a targeted review of 23 banks with material prime brokerage arms in 2022. The review resulted in a draft report on sound practices in counterparty credit risk governance and management on which the ECB has been consulting.
What is counterparty credit risk?
CCR is the risk that the counterparty may default on amounts owed on a derivative transaction or securities financing transaction (“SFT”). It is a hybrid between credit and market risk and depends on both changes in the situation of the counterparty and movements in underlying market risk factors.
Key lessons of the report
The targeted review included 23 banks that have a significant exposure to derivatives and SFTs. Almost all of the banks engaged in total return swaps and collateral swaps with different reference assets. Archegos’ use of total return swaps allowed it to avoid disclosure rules and mislead counterparties, which proved fatal for Credit Suisse, which lost over EUR 5 billion in the family office’s collapse.
The ECB’s review included four areas of assessment and the ECB found room for improvement in all of them. The ECB also identifies 43 specific best practices across these areas and asks banks to follow these “in a way commensurate with their CCR profile”.
The ECB’s overall conclusion is that there are several material shortcomings concerning the handling of CCR risks as compared to the good practices identified.
- Customer due diligence: Banks should improve their customer due diligence (CDD) processes for NBFIs, both at onboarding and on an ongoing basis. Banks should be more conservative in granting credit limits and margins to clients that are intransparent about their trading strategies, policies and procedures, or that use complex and opaque structures or instruments.
- Senior management overview: Banks should have a dedicated CCR reporting to their senior management to enable to board to understand the current and future exposure, potential losses and their likelihood, and the risk appetite and limits for CCR. Most banks currently treat CCR as part of the credit risk reporting, which may not capture the specificities and complexities of CCR.
Risk control, management and measurement
- Risk appetite statement: Banks with material or complex CCR exposures should have an explicit risk appetite statement for CCR instead of capturing it in credit risk, which is likely to increase attention at management level.
Stress-testing and wrong-way risk
- Stress testing framework: The stress-testing framework should address the creditworthiness and vulnerability of counterparties to specific exposure tail events, with focus on solvency, liquidity, concentrations, and rapid deleveraging, and influence decision-making for proactive risk mitigation.
- Wrong-way risk (WWR): Banks should identify, measure, monitor, and mitigate WWR, which is the risk when exposure to a counterparty correlates positively with the probability of default of that counterparty. For example, when a bank lends money to a hedge fund that invests in the same or related assets as the collateral. The ECB found evidence that WWR is not appropriately managed across institutions, and expects banks to establish a dedicated WWR framework and sound WWR assessment and monitoring.
Watchlist and default management process
The public consultation period on the report ended on 14 July 2023. The ECB will now consider the feedback and then publish the comments alongside a summary feedback statement and the final version of the report. Based on the timelines for previous consultations, we would expect the final guidance to be available in the fourth quarter, before the end of 2023.
The draft report is a valuable source of guidance for Eurozone banks exposed to CCR, and a signal of the ECB's supervisory expectations and priorities. Institutions should expect to find themselves benchmarked against the good practices set out in the report. At the same time, the ECB stressed that practices still to be adapted for the specific situation of the institution, and the overall principle should be to strengthen banks’ CCR risk management capabilities.
Additionally, the best practices identified will not remain static and banks should expect them to evolve over time, in line with business practices.