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    FED, PRA, and FCA Set Out Expectations for Risk Management at Banks

    December 10, 2021

    The Prudential Regulation Authority (PRA) published a Direction for modification by consent on the treatment of assets representing claims on the European Economic Area central governments. PRA is offering a modification by consent with respect to certain rules in the Liquidity Coverage Ratio (LCR) Part of the PRA Rulebook. The Direction allows any Capital Requirements Regulation (CRR) firm or CRR consolidation entity to continue treating certain such government assets as Level 1 high-quality liquid assets (HQLA) for the purpose of the LCR and net stable funding ratio (NSFR). Modifications will take effect on or after January 01, 2022 and remain in place until the modification has been revoked, varied, or superseded or until the relevant rules have been revoked or no longer apply to the firm. In addition, PRA and the Financial Conduct Authority (FCA) as well as the Board of Governors of the Federal Reserve System (FED) issued letters to banks on the supervisory expectations, following a review of the default and failure of Archegos Capital Management.

    The FED letter sets out the supervisory expectations for counterparty credit risk management and margin practices at large banks. The letter also sets out existing practices that do not meet supervisory expectations and identifies ways to mitigate these practices. The letter states that the failure of Archegos Capital Management resulted in over USD 10 billion in losses across several large banks. The letter highlights that regardless of the type of client, banks are expected to undertake proper due diligence with a client and take fully into account the risks that a relationship with a client may pose to the bank. In its letter, FED highlights that firms should:

    • Receive adequate information with appropriate frequency to understand the risks of the investment fund, including position and counterparty concentrations, and either reconsider the relationship or set sufficiently conservative terms for the relationship if the client does not meet appropriate levels of transparency
    • Ensure that the risk-management and governance approach applied to the investment fund is capable of identifying the fund's risk initially and monitoring it throughout the relationship
    • Ensure applicable areas of the firm—including the business line and the oversight function—are aware of the risk their investment fund clients pose to the firm and have tools to manage that risk
    • Ensure that margin practices remain appropriate to the fund's risk profile as it evolves, avoiding inflexible and risk-insensitive margin terms or extended close-out periods with their investment fund clients

    The letter from PRA and FCA also sets out key supervisory expectations, following a review of the global equity finance businesses, post the default of Archegos Capital Management. The letter and its Annex set out the key observations and expectations in the areas of business strategy and organization, onboarding and reputational risk, financial risk management controls and governance, and liquidation and close-out. The key observations cover weaknesses in the holistic management of risk across business units, narrow focus of onboarding arrangements and inadequate re-assessment of client relationships thereafter, ineffective and inconsistent margining approaches, and an absence of comprehensive limit frameworks. This episode of the failure of Archegos Capital Management revealed important lessons to learn for risk management in equity financing businesses of firms; these learnings will help to ensure that the risks associated with non-bank leverage do not lead to financial stability issues in the future. PRA and FCA expect firms to conduct a systematic review of their equity finance business, with their risk management practices and controls benchmarked against the findings set out in the letter. Firms are required to report their findings to PRA and FCA, along with the detailed plans for remediation, where relevant, by the end of the first quarter of 2022.

     

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    Keywords: Americas, Europe, US, UK, Banking, Securities, Counterparty Credit Risk, Archegos Capital Management, Governance, Liquidity Risk, LCR, NSFR, PRA Rulebook, HQLA, CRR, Onboarding Risk, PRA, FCA, FED

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