In a supervision and regulation letter to institutions that have large derivatives portfolios and relationships with investment funds, the Federal Reserve Board ("FRB") reiterated previously issued expectations as to large banks' counterparty credit risk management and margin practices.
After an investigation into the cause of the Archegos Capital Management default, which resulted in over $10 billion in losses to banking organizations, the FRB reminded banking organizations of their obligations to conduct and maintain due diligence and recommended that firms obtain information regarding the size, leverage, and largest or most concentrated positions of a fund, as well as its access to other lines of credit.
The FRB cautioned banking organizations that poor communication frameworks and inadequate risk management functions, as well as fragmented systems and ineffective governance, hamper their ability to identify and address risk. Further, the FRB warned lenders about agreeing to margin terms inappropriate to the risks of their investment fund clients. Consistent with the guidance in Interagency Supervisory Guidance on Counterparty Credit Risk Management, the FRB recommended that firms should:
- receive adequate information with appropriate frequency to understand the risks of the investment fund, including position and counterparty concentrations;
- ensure the risk-management and governance approach applied to the investment fund is capable of identifying the fund's risk and monitoring it throughout the relationship; and
- 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.
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