Bank credit risk: how well do you know your counterparties?

As financial markets evolve, evaluating the complex credit risk exposures of non-bank counterparties is crucial for effective risk management, says Quantifi’s Dmitry Pugachevsky

Dmitry Pugachevsky, Quantifi

In 1998, the financial world was shaken by the near collapse of Long-Term Capital Management (LTCM), a heavily leveraged hedge fund. The failure of Archegos Capital Management in 2021 echoed similar themes of excessive risk-taking and revealed crucial gaps in how banks manage exposure to investment funds. These events highlight the importance of regulators being prepared for future crises and ensuring robust counterparty risk management practices.
 

From LTCM to Archegos: lessons in market complexity

One striking parallel between these two collapses lies in the complexity and interconnectedness of modern financial markets. Archegos’s collapse underscores the intricate web of derivatives contracts, margin loans and opaque trading strategies that can amplify risks and exacerbate losses. These sophisticated financial instruments, which have become increasingly prevalent in modern markets, pose significant challenges for banks in accurately assessing and mitigating their exposure.

Moreover, the sheer size and influence of investment funds such as Archegos have increased substantially since the LTCM debacle. The rise of megafunds and the proliferation of highly leveraged strategies have magnified the potential widespread impact of a fund’s failures. As such, the downfall of Archegos serves as a stark reminder of the systemic risks inherent in the modern financial landscape and the pressing need for more robust risk management practices.

Assessing the liquidity profile of counterparties’ assets allows institutions to gauge their ability to meet obligations and withstand liquidity shocks

Regulators and financial institutions are now reassessing risk management frameworks and enhancing oversight in the hedge fund industry in response to the Archegos crisis. While reforms may address some vulnerabilities, the event serves as a reminder of the ongoing challenges in maintaining financial stability amid a complex and interconnected landscape.
 

Evaluating non-bank counterparties: liquidity matters

The US Federal Reserve’s recent emphasis on non-bank counterparties represents a significant shift in the regulatory landscape, reflecting the evolving nature of financial markets and the need for adaptive risk management strategies. Traditionally, banks viewed other financial institutions and sovereign entities as the primary sources of counterparty risk. However, as the financial landscape has transformed, with the rise of hedge funds, family offices, asset managers and pension funds as major players in the global economy, regulators recognise the imperative to broaden their focus.

This shift is significant, as non-bank counterparties present distinct challenges to risk management. Unlike traditional banks, these entities operate diverse business models, investment strategies and risk appetites. Therefore, evaluating the liquidity and concentration of non-bank counterparties becomes crucial for effective risk mitigation.

By analysing the composition of counterparties’ exposures and identifying commonalities among them, institutions can better assess the potential impact of concentrated defaults on their portfolios

Understanding the liquidity profiles of non-bank counterparties is vital for banks and regulators. Illiquid positions or excessive leverage can magnify risks and potentially trigger systemic disruptions during market downturns or liquidity shocks. Additionally, assessing counterparty concentration helps identify contagion risks and systemic vulnerabilities. As non-bank counterparties continue to gain prominence, regulators must adapt supervisory frameworks to address emerging risks effectively. This includes improving data collection, enhancing reporting requirements and implementing stress tests to assess resilience against adverse market conditions.
 

Addressing correlation risk

Central to effective counterparty credit risk (CCR) management is gaining a comprehensive understanding of the liquidity and concentration of counterparties. This involves examining their operations, assessing their financial health and evaluating their exposure to various market risks. However, one of the most difficult challenges in CCR management lies in assessing correlation risk – particularly between counterparties’ defaults. Unsurprisingly, the Fed included in its recent exploratory analysis the event of default of a bank’s five largest counterparties.

Correlation risk refers to the degree to which the default of one counterparty is correlated with the default of another. While traditional metrics such as valuation adjustments – known collectively as XVAs – provide valuable insights into the credit risk associated with individual counterparties, they often fail to account for correlation among defaults. This underlines the need for sophisticated risk models that are tailored to specific correlation parameters.

Sophisticated risk models allow financial institutions to simulate various scenarios and assess the potential impact of correlated defaults on their portfolios. By incorporating correlation risk into their risk models, institutions can better quantify and manage their exposure to systemic risks arising from interconnectedness within the financial system. Additionally, these models help spot concentration risk within counterparties’ portfolios. By analysing the composition of counterparties’ exposures and identifying commonalities among them, institutions can better assess the potential impact of concentrated defaults on their portfolios.
 

Margin, liquidity and pricing

Alongside correlation risk, other crucial key factors – such as margin requirements, liquidity of assets and the ability to obtain accurate pricing during market disruptions – are gaining increasing prominence. These factors are pivotal in ensuring robust risk management frameworks and mitigating systemic risks within the financial system.

The downfall of Archegos serves as a stark reminder of the systemic risks inherent in the modern financial landscape and the pressing need for more robust risk management practices

Margin requirements play a crucial role in risk management by acting as a buffer against potential losses. By stipulating the amount of collateral counterparties must maintain, margin requirements help mitigate counterparty credit risk and prevent excessive leverage. Furthermore, the liquidity of assets held by counterparties is a key determinant of their resilience during periods of market stress. Illiquid assets pose challenges in terms of valuation and disposal, potentially exacerbating losses during turbulent market conditions. Assessing the liquidity profile of counterparties’ assets allows institutions to gauge their ability to meet obligations and withstand liquidity shocks.

The ability to obtain accurate pricing during market disruptions is essential. Market disruptions can lead to heightened volatility and dislocations, making it challenging to accurately value assets and assess risks. Institutions must have robust pricing mechanisms in place to navigate these challenges and make informed decisions amid market turbulence.
 

Tailored risk management

As non-bank entities gain significance in financial markets, regulators must adjust supervision to tackle emerging risks effectively. This involves enhancing data collection, stress-testing and scenario analysis to gauge resilience to adverse market conditions. Firms benefit from integrating counterparty credit and market risk management, and are urged by regulators to use portfolio simulation models for a comprehensive view of exposures, considering netting and collateral agreements.

As non-bank counterparties continue to gain prominence, regulators must adapt supervisory frameworks to address emerging risks effectively

Quantifi provides support for monitoring and managing limits across risk measures to consolidate counterparty exposures. Its solution includes various credit risk measures, such as expected exposure, potential future exposure, regulatory capital and economic capital. Additionally, Quantifi enables automation of credit management processes, with features such as counterparty relationship modelling, grading and customisable limit assignment workflows.

Quantifi accommodates different risk management structures, whether institutions employ central risk control groups or delegate counterparty risk responsibility to specific business units. Quantifi can function as a core solution or integrate seamlessly with existing platforms to enhance risk management capabilities for specific portfolio subsets.
 

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