The U.S. Federal Reserve on Friday reinforced lessons it shared with banks to keep a close watch on their institutional trading partners after the $10 billion blowup of Archegos Capital Managed exposed counterparty risk in the financial system.
The move came after Archegos Capital Management, an investment firm concentrated in a small number of U.S. and Chinese technology and media companies, defaulted on March 26, setting off a chain reaction that led to $10 billion in losses across several large banks.
The Fed revealed last month that the losses exposed vulnerabilities, and have now followed up with more guidance for banks to step up their due diligence efforts.
“When initiating a relationship and on an ongoing basis, firms should obtain critical information regarding size, leverage, largest or most concentrated positions, and number of prime brokers with sufficient detail or frequency to determine the fund’s ability to service its debt,” said a letter to banks from Michael S. Gibson, director of the Division of Supervision and Regulation at the Fed.
“If a client refuses to provide this information, firms should consider whether it is consistent with safe and sound practices for them to begin or maintain a relationship with the fund or whether they can use strong compensating measures, such as significantly more stringent contractual terms, to mitigate the risk,” Gibson said.
Gibson said his recommendations remain consistent with its interagency supervisory guidance on counterparty credit risk management, which promotes failsafes for banks.
Banks should receive adequate information with appropriate frequency to understand the risks of the investment fund; ensure 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; and ensure that margin practices remain appropriate to the fund’s risk profile as it evolves, Gibson noted.
Banks should also avoid inflexible and risk-insensitive margin terms or extended close-out periods with their investment fund clients.