Three years have passed since the banking sector was rocked by the collapse of Archegos Capital Management (Archegos), resulting in $10 billion of cumulative losses for some of the largest and most sophisticated investment banks. Events surrounding the 2021 default were back in the spotlight recently when the firm’s founder, Bill Hwang, was convicted of market manipulation by a US federal court in July 2024.
While the Archegos saga stands out for many reasons, it is not the first time that Wall Street has suffered losses from a large counterparty default, witness the failures of MF Global (2011), Lehman Brothers (2008), AIG (2008) and Long-Term Capital Management (LTCM) (1998). What do these failures have in common? Counterparty risk.
Counterparty risk, inherent in most trading and secured financing activity, is multi-dimensional, dynamic, and bilateral in nature, making it one of the most complicated risks to identify, assess, monitor, and manage. Moreover, it is linked with other risks, notably liquidity risk, which directly impacts the ability of financial institutions to meet credit obligations. In this article, we highlight what banks should expect from regulatory agencies and supervisors, as well as the steps they should take to prepare for prolonged and intense scrutiny from these organizations.
SUPERVISORY AND REGULATORY RESPONSE TO COUNTERPARTY DEFAULTS
The implosion of LTCM in 1998 was a wakeup call for the banking industry and its supervisors. It meant that counterparty risk was now a major risk category for large banks and supervisors on both sides of the Atlantic.
Regulators and supervisors responded quickly. The Bank for International Settlements (BIS) issued its original guidance, Sound Practices for Banks’ Interactions with Highly Leveraged Institutions, in January 1999.1 The Federal Reserve (FRB) followed suit in February 1999, issuing its initial Supervisory Guidance Regarding Counterparty Credit Risk Management (SR 99-3).2 A decade later in 2011, following the global financial crisis, US agencies published interagency guidance, Interagency Supervisory Guidance on Counterparty Credit Risk Management.3
Since 2021, there has been a fresh wave of regulation and supervisory announcements. In August 2022, the European Central Bank (ECB) released its Supervisory Expectations for Prime Brokerage Services,4 that highlighted the limitation of one-dimensional risk measures in counterparty risk measures and limit monitoring. The ECB followed that up in October 2023 with its release of Sound Practices in Counterparty Credit Risk Governance and Management.5
Next, the BIS issued a consultive document on Guidelines for Counterparty Credit Risk Management in April 2024.6 This update builds on its 1999 guidance and addresses issues that have emerged since the original publication. These include transparency in client onboarding, comprehensive risk mitigation strategies, counterparty risk measurement and control, and governance frameworks.
In May 2024, Michael Barr, Vice Chair for Supervision at the Federal Reserve, outlined the organization’s latest recommendations. Barr highlighted the need for stricter risk oversight for high-profile investment funds, acknowledging that "managing these exposures has become more challenging as the financial system has grown more complex, diverse, and interconnected".7 Key topics highlighted by Barr include stricter Know Your Customer (KYC) due diligence practices, enhancing risk measurement and reporting tools, and strengthening risk management practices for establishing and overseeing limit frameworks.
Most recently, the Federal Reserve released the results of its 2024 stress tests, including new ‘Exploratory Market Shock Scenarios’. One such scenario conducted with the eight US. Global Systemically Important Banks (G-SIBs) simulated hypothetical defaults from each bank’s five largest hedge fund counterparties simultaneously, resulting in aggregate losses of $22 billion. The Federal Reserve notes that “bank exposures to hedge funds have risen over the past several years, and at the same time, hedge fund leverage has increased”.8
ADDRESSING INCREASED SCRUTINY
The largest banks, particularly those with sophisticated prime brokerage businesses, have been under intense scrutiny from supervisors and policymakers since Archegos imploded. These firms have materially enhanced their risk management processes, but there is more to do across the industry to keep pace with heightened expectations. We expect to see continued scrutiny of counterparty risk management practices into the foreseeable future and that this will be applied not just to the largest banks, but to a wider range of institutions.
Below are the key activities and actions that banks should consider in response:
DUE DILIGENCE
The ECB, Federal Reserve, and BIS have emphasized the importance of rigorous due diligence and continuous monitoring to mitigate counterparty risk, especially within prime brokerage businesses. Although counterparty due diligence begins at the initiation of the relationship (e.g. KYC and initial credit assessment), it must continue throughout the relationship. We expect banks to adopt stricter reporting protocols, which will require more detailed data and frequent interactions. This will be particularly important when transacting with levered counterparties.
By applying enhanced due diligence, banks will acquire a comprehensive understanding of trading strategies and associated risks across all their counterparty relationships. This will also enable banks to act rapidly and confidently during times of stress. As Barr says: “Banks should know their customers exceedingly well, both at onboarding and throughout the evolution of the relationship.”7
EXPOSURE ASSESSMENT
Banks must be able to measure counterparty risk at all appropriate levels of aggregation and over the lifetime of the exposure. Credit risk management focuses on controlling concentration risks, such as tall tree risk to individual borrowers, industry concentration risk, and country concentration risk.
Historically, institutions measured counterparty risk using probabilistic methods such as potential exposure modelling at a quantile corresponding to the bank’s risk appetite. While these assessment methodologies are useful for uncollateralized counterparties, such as an interest rate swap with a corporate client, they are less effective for collateralized counterparties.
For collateralized counterparties, particularly hedge fund counterparties, banks have increasingly relied on deterministic stress tests and scenario analyses. These stress tests should be tailored to the bespoke strategies employed by each fund archetype. For example, a scenario designed to tease out risks within a client’s long / short equity portfolio would likely have no impact on a fund employing a macro trading strategy.
Last but not least, the overall size of a portfolio matters. This was one of the main lessons from the Archegos fallout. Whatever risk measurement techniques banks choose to deploy – probabilistic, deterministic, notional – they should directly inform limits evaluation.
GOVERNANCE
The limit framework operationalizes a bank’s tolerance for counterparty risk in the pursuit of its strategic objectives. However, any limit framework must be supported by a strong risk culture and robust governance. As the Archegos saga demonstrates, if you don’t have such a culture in place, there is a far greater risk of minor issues becoming unacceptably large.
Essential components of a limit framework include accountability, clear communication protocols across the organization, prompt resolution of issues, and effective escalation procedures for handling exceptions. Banks should also prioritize rigorous oversight, establish formal timelines for resolving exceptions, and conduct proactive risk monitoring. Management reporting should clearly highlight counterparty concentrations and aged limit breaches.
INFRASTRUCTURE, DATA AND TECHNOLOGY
The ability to measure risks and make timely, well-informed decisions begins foundationally at the data layer. Even the best risk models are only as good as the quality and consistency of the data upon which they are built. As a result, effective counterparty risk management requires significant amounts of data supported by efficient modelling and a robust technology infrastructure.
Some banks that suffered losses from the Archegos default were constrained by fragmented data systems that prevented a consolidated view of total exposure. Furthermore, advances in risk technology, such as real-time monitoring, are crucial for quickly detecting significant changes in exposure. This aligns with the ECB’s emphasis on the integration of advanced risk monitoring systems that provide real-time updates on client exposures.
CLOSEOUT PROCEDURES
Closing out a large counterparty is conceptually simple but can be extremely complicated in practice. Key steps include legal confirmation of contractual rights, internal approvals to initiate the closeout process, delivering notices of default, booking risk into firm trading accounts, hedging or liquidating risk, crystallizing the P&L impact, and preparing this information for the bankruptcy court.
Banks should ensure their closeout playbooks include the latest regulatory guidance and lessons learned, both from supervisory feedback and from industry best practice. Leading banks have already invested in systematic and query-able capture of all legal terms. Finally, periodic default simulations will prepare the institution for a variety of closeout scenarios.
FINAL THOUGHTS
The largest banks, particularly those directly impacted by the Archegos default, are under intense scrutiny to improve their data, infrastructure, risk assessment, and risk reporting capabilities. Recent guidance from the ECB, BIS, as well as statements from the FRB indicate that this topic remains top of mind for bank supervisors. Banks should continue to bolster their internal controls and risk management frameworks to meet heightened regulatory scrutiny and ensure that they remain resilient against future systemic and idiosyncratic shocks.
REFERENCES
1 https://www.bis.org/publ/bcbs46.htm
2 https://www.federalreserve.gov/boarddocs/srletters/1999/sr9903.htm
3 https://www.fdic.gov/sites/default/files/2024-03/fil11053a.pdf
4 https://www.bankingsupervision.europa.eu/press/publications/newsletter/2022/html/ssm.nl220817_3.en.html
5 https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.supervisory_guides202310_ccrgovernancemanagement.en.pdf
6 https://www.bis.org/bcbs/publ/d574.pdf
7 https://www.federalreserve.gov/newsevents/speech/barr20240227a.htm
8 https://www.federalreserve.gov/publications/files/exploratory-analysis-results-20240626.pdf