The document outlines the governance and management practices for counterparty credit risk (CCR) identified by the European Central Bank (ECB) following a targeted review of 23 financial institutions. It highlights the ECB's expectations regarding risk management, particularly in the context of prime brokerage services and non-bank counterparties. Emphasis is placed on the importance of robust governance and…
This document is a guide published in 2023 by the European Central Bank (ECB) - Banking Supervision (Single Supervisory Mechanism, SSM). It covers best practices in governance and management of counterparty credit risk (CCR) in financial institutions. The scope includes European banks active in derivatives and securities financing transactions (SFTs), focusing on the recent period up to 2022-2023. The guide is based on a targeted review conducted in 2022 among 23 institutions significantly exposed to CCR, complemented by on-site inspections. It also incorporates European regulatory expectations (CRD, CRR, EBA Guidelines) and international ones (BCBS, FSB).
The document addresses governance and management of counterparty credit risk (CCR), a risk increased by the growth of capital markets activities with non-bank counterparties, notably non-bank financial entities (NBFI) and less regulated counterparties. This topic is crucial as CCR can cause significant losses, as illustrated by the failure of Archegos Capital Management. In 2022, the ECB conducted a targeted review among 23 European banks active in derivatives and SFTs to assess their CCR governance and management practices. The main findings reveal progress but also significant gaps, notably in client due diligence, explicit integration of CCR into risk appetite, frequency and use of stress tests, management of risks related to distressed counterparties, and management of wrong-way risk (WWR). The document presents 43 observed best practices, grouped into four areas: governance, risk control and measurement, stress testing and WWR, and watchlist and default management. Recommendations emphasize the need for clear governance with a three lines of defense model, dedicated resources, detailed reporting to management, rigorous collateral management, strong CCR integration into risk policies and limits, comprehensive stress testing including WWR scenarios, and robust processes for monitoring and managing distressed counterparties. These practices must be adapted to the complexity and size of institutions’ CCR portfolios. Follow-up of observations is an integral part of the supervision process and may lead to complementary inspections. In summary, this guide aims to strengthen banks’ resilience to CCR risks by promoting rigorous and adapted management practices in a complex and evolving market environment (p. 1-33).
Since the 2007-08 financial crisis and earlier events (LTCM, Archegos), CCR is recognized as a major risk requiring increased vigilance. The ECB identified CCR as a supervisory priority for 2022-24, especially in the context of increased market volatility, notably related to the war in Ukraine. The guide is based on a targeted review conducted in 2022 among European banks active in derivatives and SFTs with non-bank counterparties, complemented by on-site inspections. The objective is to present observed best practices in CCR governance and management, assess banks’ convergence towards these practices, and encourage improvement proportional to each institution’s complexity and risk profile. The guide stresses that practices must evolve with market changes and counterparty profiles, notably NBFI and other entities vulnerable to market shocks. It aims to go beyond mere regulatory compliance to promote proactive and robust CCR management (p. 3-6).
CCR Governance:
- CCR is managed according to a three lines of defense model, with clear responsibilities between 1LoD (business lines), 2LoD (credit risk control including a dedicated CCR team in complex institutions), and 3LoD (internal audit).
- Risk or credit committees include CCR, but few institutions have dedicated committees. Meeting frequency varies from monthly to quarterly.
- Reporting to management is often integrated into overall credit reporting, with key elements such as exposure evolution, concentration, stress tests, and WWR analysis.
- Collateral management is organized in dedicated units, with dispute management processes and regular reporting to management.
- Client due diligence is crucial, impacting credit decisions, with particular attention to vulnerable clients and transparency of provided information.
- New product approval includes an explicit CCR assessment.
Risk Control, Management and Measurement:
- The risk appetite framework (RAF) must explicitly include CCR, notably in institutions with complex portfolios.
- CCR risk policies are often integrated into credit policies, but some institutions lack dedicated policies.
- CCR limits are set and monitored by 2LoD, with daily monitoring of counterparty limits and monthly to weekly for aggregate limits.
- Multiple metrics are used: risk-weighted exposure amount (RWEA), exposure value (EV), stress measures, etc.
- Concentration and collateral illiquidity are monitored via eligibility criteria and concentration limits.
- Few institutions calculate economic measures for the CCR portfolio stop-loss cost beyond regulatory requirements.
Stress Testing and WWR:
- CCR stress tests are conducted regularly, covering historical and ad hoc scenarios, but their integration into risk management is uneven.
- Macroeconomic stress tests are common, but tests specific to risk factors are less widespread.
- Most institutions use credit portfolio models in ICAAP, but consistent CCR integration in these models remains limited.
- WWR frameworks (general and specific) are in place in the most advanced institutions, with identification, measurement, limits, and reporting.
- Some institutions do not always comply with regulatory requirements, notably regarding SWWR treatment.
Watchlist and Default Management:
- Watchlist processes are in place in most banks, but often limited to general credit risk criteria.
- About half of institutions negotiate risk mitigation measures with watchlist clients, including secured settlement procedures and increased collateralization.
- Default management policies are generally well defined with clear responsibilities.
- Most banks conduct regular "fire drills" to test default management procedures.
These themes illustrate the diversity of practices and areas where improvements are needed, notably in formalization, integration, and frequency of controls and reporting (p. 13-36).
Findings:
- Selected banks held approximately €1,245 billion of CCR exposure at the end of March 2022, with 59% in derivatives and 41% in SFTs.
- The majority use the internal model approach (IMM) to measure CCR, especially for derivatives.
- Counterparties include CCPs, banks, corporates, and NBFI, with notable concentration on CCPs and banks.
- Netting agreements (GMRA, GMSLA, ISDA) are widely used, often combined with margin agreements.
Assumptions and Interpretations:
- The complexity and nature of CCR portfolios vary strongly across institutions, influencing management practices.
- Some observed practices are adapted to risk profiles and bank size, but others require improvements to address CCR-specific risks.
- The lack of explicit CCR integration in risk policies and RAF may underestimate risks.
- Insufficient stress test frequency and absence of systematic use of results limit the ability to anticipate extreme risks.
Uncertainties:
- Rapid market evolution and counterparty profiles, notably in the NBFI sector, may render some practices obsolete.
- Institutions’ capacity to adapt their CCR frameworks to these changes remains variable.
- The impact of negotiated mitigation measures with distressed clients on effective risk reduction is difficult to quantify.
These results highlight the need for continuous improvement in CCR management practices, particularly in stress testing, WWR consideration, and proactive management of at-risk counterparties (p. 6-11, 21-33, 34-38).
The guide concludes that despite notable progress, many institutions must strengthen their CCR governance and management practices to better control associated risks. Key recommendations are:
- Establish a clear three lines of defense model with well-defined responsibilities and adequate resources for all CCR counterparties.
- Formalize a dedicated CCR framework, including explicit policies in the RAF and limits adapted to portfolio complexity.
- Enhance client due diligence, notably for NBFI and vulnerable counterparties, with direct impact on credit decisions.
- Improve frequency, scope, and integration of CCR stress tests, including WWR scenarios and use of results for proactive risk management.
- Develop robust processes for monitoring and managing distressed counterparties, with CCR-specific watchlists and clear default management policies.
- Ensure detailed and regular reporting to management on CCR exposures, concentrations, stress test results, and WWR risks.
- Conduct holistic and regular internal audits to guarantee CCR framework effectiveness.
- Adapt practices to market evolutions and counterparty profiles, especially in the NBFI sector.
These recommendations are integrated into the ECB’s ongoing supervision process, with follow-up of observations and expected corrective actions, including on-site inspections if necessary (p. 20-21, 26-33, 34-38).
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