Joint Forum Releases Report on Credit Risk Management Across Sectors (with Lofchie Comment)

The Joint Forum, which consists of the Basel Committee on Banking Supervision, IOSCO and the International Association of Insurance Supervisors, released a report titled "Developments in Credit Risk Management Across Sectors: Current Practices and Recommendations."

The report provides insight into the current supervisory framework around credit risk, the state of credit risk management at firms, and implications for the supervisory and regulatory treatment of credit risk. The report is based on a survey that the Joint Forum conducted globally with 15 supervisors and 23 firms in the banking, securities and insurance sectors.

The Joint Forum put forth the following recommendations for consideration:

• supervisors should be cautious about overreliance on internal models for credit risk management and regulatory capital;
• supervisors should be cognizant of the growth of certain risk-taking behaviors and the resulting need for firms to have appropriate risk management processes, given the current low interest rate environment possibly generating a "search for yield" through a variety of mechanisms;
• supervisors should be aware of the growing need for high-quality liquid collateral to meet margin requirements for OTC derivatives sectors. The Joint Forum should consider taking appropriate steps to promote the monitoring and evaluation of the availability of such collateral in their future work while also considering the objective of reducing systemic risk and promoting central clearing; and
• supervisors should consider whether firms are accurately capturing central counterparty exposures as part of their credit risk management.

Lofchie Comment: The government and the regulators vastly oversold the benefits of central clearing without attending to the risks that it creates (e.g., that central counterparties are too big to fail, and that because they can demand unlimited initial margin, they may drain liquidity from the markets when there is a downturn). The new caution that banks must be mindful of their central counterparty risk has very negative implications for the economy. In the old pre-Dodd-Frank world, if a bank did not have confidence in the creditworthiness of one swap counterparty, or believed it was overly exposed to a particular swap counterparty, it could take its business elsewhere. In the Dodd-Frank world, the major clearinghouses have monopolistic or duopolistic positions with respect to certain products. Thus, if a bank does not have confidence in a clearinghouse, or believes it is too exposed to the clearinghouse, the bank would likely have to shut down its swaps business in a particular product, even though the transaction is sensible for the bank and good for its customer. In short, the belated realization that central counterparty risk may shut down transactions is not good news for the economy.By coincidence, a related point is made in another story published today: Dodd-Frank regulations have effectively forced small FCMs out of business, with the result that tremendous amounts of risk are being concentrated in a very small number of huge FCMs.

See: "Developments in Credit Risk Management Across Sectors: Current Practices and Recommendations"; IOSCO Press Release. Related news: Joint Forum of International Regulatory Organizations Issues Publication on Credit Risk Management across Sectors(February 5, 2015).