BoE on Lehman's lessons for bank booking structure

With the focus turning increasingly to the resolvability of financial institutions, the Bank of England’s Megan Butler and Andy Murfin warn banks to make their derivatives booking structures as coherent and transparent as possible, or be forced to simplify them

Bank of England: booking structures should be clear, transparent and coherent

London has long been host to international investment banks, which use the UK as a derivatives booking hub, both for trading with European clients and for the centralised risk management of positions originating elsewhere in their global operations. As much as 40% of the revenues of UK-based overseas investment banks are generated from business that is remotely booked from overseas into the major UK subsidiaries.

In accommodating firms' global trading businesses, the Bank of England has always encouraged banks and broker-dealers to make their booking structures as clear, transparent and coherent as possible. Recent attention on the resolvability of institutions in the event of severe stress or failure has brought the issue into sharper focus.

A key lesson we took from the Lehman Brothers failure was that the more complex the derivatives booking practices are, the less knowledge there is about the interdependencies of those books. This results in worse oversight and makes it much more difficult to unwind those trades. Many firms have already improved their structures and controls. But, where there are still booking structures for which there is no coherent rationale, and which are exceedingly complicated, we do require that firms simplify them.

We recognise that the major UK investment banks operate globally and serve an international client base. For example, the UK subsidiary may be providing a US credit default swap for an Asian client, which might want to deal with an entity from a particular jurisdiction or centralise all its global dealings with a single legal entity to maximise its netting benefits. With such a global structure, there is no unique organising principle for how risk management should be run.

The investment bank may want to manage the risks of a particular business line globally and centralise risk management. Such centralisation can facilitate effective risk hedging, avoiding exposures being split across entities. There can be benefits from the focus of centralised expertise and the associated clear control arrangements – it can improve the visibility of risk for both firms and regulators, for instance.

The more complex the derivatives booking practices are, the less knowledge there is about the interdependencies of those books

Alternatively, the firm may want to manage its risks within the region of origin. This can be particularly attractive where either expertise in features of the local market or access requirements play a strong role in risk management, such as in equity markets.

The UK Prudential Regulation Authority's (PRA) primary supervisory focus is on the UK subsidiaries of these groups, which has several implications. The rationale for the local legal entity's booking structure should be clear, coherent and understandable. There should be an alignment of the firm's business risk, its profit and loss, and its balance sheet. Banks have often accumulated diverse booking practices piecemeal over time. The arrangements may need refreshing to ensure there is a coherent and transparent over-arching business model.

Most global firms run a combination of centralised and regional risk management approaches across different asset classes. Those booking into the UK under either arrangement will need to ensure they have a robust risk management framework in place to meet their safety and soundness obligations. The interests of the firm and the regulator are aligned in this respect.

In particular, the local legal entity must be in control of what is booked on to its balance sheet. The UK subsidiary must understand the risks it is taking on, especially when the trades it accepts are booked in from remote locations. The board of the local legal entity in the UK is responsible for the risks on its balance sheet, and it needs the authority and autonomy to control them – including being able to say ‘no'.

Where a firm transfers market risk between entities as part of its centralised risk management, it is good practice to manage these transfers to similar standards as used for external third-party trades, with proper documentation and identification of the risks of each transaction.

There can be advantages for risk oversight and resolvability in having those derivatives and cash products that are hedges of each other located within the same entity. Where this is not practicable, firms still need to deliver proper oversight of the overall risk.

Where we identify weak risk management practices, we need to be sure the firm can first manage the risks originating within the region effectively before adding risks from outside. The PRA requires the standards of firms' risk management to be aligned with the level of risk they are running, as set out in our supervisory approach document.

There is no restriction on the regional source of any business being booked remotely into a UK entity, as long as it has a good rationale for the proposed structure and can demonstrate the capability to effectively manage the risks it wants to take on.

Overall, the booking structure should not impede an orderly wind down or resolution. It should not make it harder for either the local entity to continue in resolution, given its reliance on services from the rest of the group, or to separate any entity from the wider group.

Megan Butler is an executive director of international banking supervision at the Bank of England. Andy Murfin is a senior adviser in the same area.