Proportionality Needed in Counterparty Risk Guidelines

September 30, 2024

The collapse of Archegos Capital Management in 2021 highlighted a complex problem: how do you know whether a counterparty has built up similar exposures with multiple trading partners, leading to material concentrations that could result in heavy losses? It's an issue the Basel Committee on Banking Supervision attempted to address in a recent consultation on counterparty risk management, which we responded to last month. There's a lot in the consultation that aligns with industry best practices, but it's important that the measures are implemented with flexibility and in proportion to the risks posed.

The Basel guidelines are part of a broader effort by regulators to plug perceived vulnerabilities posed by non-bank financial intermediation. In the case of Archegos, the firm had taken exposures to certain stocks through total return swaps with multiple dealers, building a large, concentrated exposure. It subsequently defaulted on margin calls, causing dealers to terminate the positions and sell the underlying stocks they held as hedges, which led to more than $10 billion in losses for counterparty banks.

The proposals - published as more flexible supervisory guidelines rather than hard-and-fast prudential rules - are intended to incorporate market developments in counterparty risk management in recent years, focusing on due diligence and monitoring, credit risk mitigation, exposure measurement and management. While drafted with Archegos-type situations in mind, these guidelines apply to all counterparties, so it's important they are implemented in a way that reflects the business type and risk profile of each counterparty.

For example, a potential stumbling block is the recommended data banks are expected to get their hands on. As part of their ongoing credit assessment, banks will need to obtain a variety of information from their counterparties, ranging from changes in the direction of their trading activities and performance to alterations in risk management procedures and changes in key personnel. Given the proprietary nature of that data, this will be practically difficult, if not impossible - not least, because of legal or regulatory constraints on counterparties providing it.

Our response to the Basel Committee, which we submitted with the Institute of International Finance (IIF) on August 28, calls for greater recognition of the limitations banks may face in sourcing some of this information. We also think more work is needed to understand the constraints on counterparties in disclosing data to banks and to assess the huge volume of relevant data that is already available. For example, the European Securities and Markets Authority published a report showing that regulatory reporting data it receives under the European Market Infrastructure Regulation gave warning signals that Archegos had increased its exposure to certain stocks two months before its collapse - something we also pointed out in a whitepaper last year.

Importantly, the information a bank legitimately needs to manage its counterparty credit risk will inevitably vary depending on the type of entity it is dealing with, so the disclosure requirements should reflect that. The principle of proportionality is just as important in other parts of the guidance. While the Basel Committee suggests banks should use a variety of risk metrics to manage counterparty credit risk, we believe there should be some flexibility to allow the most appropriate metrics to be used for each counterparty.

Our response to this consultation is the first step in what will be an important piece of work in the years to come. The Basel Committee has recognized the need for banks and supervisors to take a risk-based and proportionate approach to the application of the guidelines. The changes we have suggested would help to further that objective, and we look forward to continued dialogue with policymakers as they review and incorporate industry feedback.

Read the Basel Committee's guidelines for counterparty credit risk management.

Read the ISDA, IIF response to the Basel Committee.