Federal Reserve Vice Chair Urges Enhanced Counterparty Credit Risk Management

 

In a pivotal speech on February 27, 2024, Vice Chair for Supervision at the Federal Reserve, Michael S. Barr, underscored the critical importance of bolstering counterparty credit risk management. Drawing insights from historical financial crises, including the Long-Term Capital Management (LTCM) debacle and the more recent Archegos Capital Management failure, Barr outlined the evolving challenges in navigating the complexities of the financial system.

The Lessons from LTCM and Archegos:

Reflecting on the LTCM crisis of 1998, where stabilization efforts narrowly averted significant financial stress, Barr highlighted the need for improved risk management practices. He drew parallels with the Archegos failure in 2021, which exposed vulnerabilities and gaps in managing exposures to investment funds. Barr emphasized the role of nonbank clients, such as hedge funds, and the evolving risks they pose to the global economy.

Progress and Challenges:

Acknowledging progress made by banks in enhancing counterparty credit risk management post-Archegos, Barr noted improved information disclosures, risk-sensitive margin practices, and enhanced risk management tools. However, he cautioned that the financial system's increasing complexity and diverse nonbank clients pose ongoing challenges. The 2022 losses in liability-driven investments of UK pension funds illustrated how even seemingly safe exposures could threaten stability when combined with excessive leverage.

Federal Reserve's Focus and Three Key Themes:

Looking ahead, Barr outlined the Federal Reserve's continued focus on fundamental risk management related to counterparty credit risk. He emphasized three key themes: 

1. Deep Customer Understanding: Barr stressed the importance of banks knowing their customers exceptionally well throughout the relationship, especially in dynamic trading activities.

  

2. Risk Identification and Measurement: Banks should employ tools to identify unique risks across products, business lines, and clients, using risk measures to maintain appropriate margins through the credit cycle.

3. Prudent Risk Limits and Response: Barr highlighted the necessity for banks to set prudent risk limits and promptly respond to signals of risk, emphasizing the importance of strong governance and risk culture.

Exploratory Analysis and International Cooperation:

Barr announced that the Federal Reserve would conduct exploratory analyses, including the resilience of globally systemically important banks to the simultaneous default of their largest hedge fund counterparties. He emphasized the importance of international cooperation, citing the Basel Committee's role in establishing consistent global standards.

In conclusion, Barr stressed that effective counterparty credit risk management is crucial in today's financial landscape, with the hedge fund industry significantly larger than in 1998. Getting it right, according to Barr, is not only in the interest of banks but also crucial for maintaining a stable and strong financial system that benefits customers and the public.