ECB Calls for Banks to Explicitly Address Counterparty Credit Risk in Risk Appetite Statements

The European Central Bank (ECB) calls for banks with complex counterparty credit risk exposures to “specify your willingness to accept this risk in your risk appetite statementinstead of implicitly capturing it in credit risk.

The ECB published this Friday its final report on “Sound practices in governance and counterparty credit risk management.”

The report now includes comments from banks from a public consultation that The ECB began at the beginning of June and concluded on July 14.

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The president of the ECB Supervisory Board, Andrea Enria, published the main aspects on counterparty credit risk in a blog in January 2023.

Compared to general credit risk, counterparty credit risk may present additional complexitiessuch as collateral that is illiquid and transactions that are difficult to replace.

Therefore, banks should consider these risks when they establish risk appetite and limits, according to the ECB.

To do this, banks need a broad set of risk metrics that cover all facets of counterparty credit risk, which occurs when the other party to the financial transaction cannot meet payment obligations on the expiration date.

The report describes good practices in relation to the governance and management of counterparty credit risks but also highlights areas where banks need to improve.

It also summarizes the results of the review carried out in the second half of 2022 on how banks govern and manage this risk.

The ECB became concerned about this risk because in the last ten or fifteen years, low interest rates led banks to increasingly offer capital markets services to riskier, more leveraged and less transparent counterparties, particularly non-banking financial institutions, to achieve higher returns.

Following the collapse of the investment fund Archegos Capital Management in March 2021, the ECB and other supervisors reviewed the risk management practices of some banks that offered many prime brokerage servicesa specific capital markets activity with high exposure to counterparty credit risk.

The ECB published its supervisory expectations for these services in August 2022.

Previously, global supervisors had already increased their surveillance of counterparty credit risk following the 1998 collapse of Long-Term Capital Management (LTCM), a hedge fund that was highly leveraged.

Banks should strengthen customer due diligence procedures where the counterparty is not a bank and this should have a substantial impact in credit decisions and contractual conditions.

If a customer does not provide information, the bank should respond more conservatively to guarantees, margins and limits to secure or even reject some clients, according to the ECB.

Banks must look at counterparties to ensure they have sufficient capacity to absorb shocks.

Likewise, the ECB recommends that banks develop appropriate and more frequent stress tests for counterparty credit risk.

He also sees room to improve how to mitigate, observe and manage This risk occurs when a counterparty has problems or does not pay, especially in the case of derivatives that are traded outside organized markets and are not cleared.

Bank management and risk committees should be informed no delay from market tensionsimportant margin disputes, counterparties in difficulty and failures in the treasury and collateral management departments.

ECB supervisors led to end of 2022 external controls in 23 active banks in derivative and securities financing transactions with non-bank counterparties.

The volatility of energy and raw material prices induced Due to the conflict in Ukraine, increased attention was paid to banks’ exposures to brokers of these securities.

EFE