Fed Vice Chair Says FRB to Focus on Supervision of Counterparty Credit Risk Management Practices

Federal Reserve Board ("FRB") Vice Chair for Supervision Michael S. Barr reported that, going forward, the Federal Reserve plans to focus on supervision over fundamental risk management related to counterparty credit risk practices.

In a speech before the Basel Committee on Banking Supervision-Federal Reserve Counterparty Credit Risk Conference, Mr. Barr highlighted the critical importance of strong counterparty credit risk management in the banking sector. He asserted that there are persistent gaps in banks' management of their exposure to investment funds.

Mr. Barr reflected on past financial crises and recent failures, such as LTCM and Archegos Capital Management, which he said exemplified the challenges posed by nonbanks and the gaps in banks' risk management practices. He noted that managing such exposures has become more challenging, as the financial system has become "more complex, diverse, and interconnected," evidenced by the sudden rise in commodities prices in March 2022 and an increasingly varied and evolving collection of nonbank clients, including pension funds and asset managers. Mr. Barr identified several key areas for improvement, including enhanced due diligence, better risk measurement and margining practices, setting and adhering to risk limits and fostering a robust risk culture within banks. He also stressed the importance of international cooperation to address these risks globally.

Mr. Barr said that the FRB plans to focus on fundamental risk management related to counterparty credit risk. He highlighted three themes:

• Banks should know their customers. Mr. Barr said that strong risk management begins with knowing your customers, including understanding a borrower's finances, exposures, history and goals. He said that lenders should continue to obtain information about the borrower after the loan is made and that banks must gather reliable and frequent information about their counterparties to make prudent decisions.
• Banks should have better tools to identify risks as they materialize. Mr. Barr said that sound counterparty risk measurement rests upon a bank's (i) "understanding [of] a counterparty's risk profile through a range of risk measurement tools," (ii) "conduct[ing] risk aggregation within and across products, business lines and clients", (iii) developing "capabilities for timely and accurate risk measurement given the dynamic and complex nature of trading activities" and (iv) maintaining "appropriate levels of margin to insulate them from loss." Mr. Barr also highlighted the importance of sound margining practices for all asset classes and stressed that weakening standards on margin or terms and conditions should not be a negotiation point to win business.
• Banks should set prudent risk limits and respond to signals. Mr Barr said that good governance and risk culture "basics" include: (i) employing skilled, capable people to manage risk, (ii) adequate staffing, (iii) strong documentation and (iv) clear roles, responsibilities and accountability. Mr. Barr underscored that, even if a bank has the "best counterparty risk measurement capabilities in the world," a firm's risk management efforts are ineffective if risks are ignored by key decisionmakers or if individuals with responsibility for managing the risk don't have influence on the firm's business decisions.

Mr. Barr stated that the FRB will publish the results of several exploratory analyses alongside the 2024 stress test results.