Bank credit risk: how well do you know your counterparties?

As non-bank entities gain significance in financial markets, regulators must adjust supervision to tackle emerging risks effectively.

In 1998, the financial world was shaken by the near collapse of Long-Term Capital Management (LTCM), a heavily leveraged hedge fund. The failure of Archegos Capital Management in 2021 echoed similar themes of excessive risk-taking and revealed crucial gaps in how banks manage their exposure to investment funds. These events highlight the importance of regulators being prepared for future crises and ensuring robust counterparty risk management practices.

One of the striking parallels between the two incidents lies in the complexity and interconnectedness of modern financial markets. Archegos’s collapse underscores the intricate web of derivative contracts, margin loans and opaque trading strategies that can amplify risks and exacerbate losses. These sophisticated financial instruments, which have become increasingly prevalent in today’s markets, pose significant challenges for banks in accurately assessing and mitigating their exposure.

Moreover, the sheer size and influence of investment funds like Archegos has grown substantially since the LTCM debacle. The rise of megafunds and the proliferation of highly leveraged strategies have magnified the potential widespread impact of a fund’s failure. As such, the downfall of Archegos serves as a stark reminder of the systemic risks inherent in the modern financial landscape and the pressing need for more robust risk management practices.

Regulators and financial institutions are now reassessing risk management frameworks and enhancing oversight in the hedge fund industry in response to the Archegos crisis. While reforms may address some vulnerabilities, the event serves as a reminder of the ongoing challenges in maintaining financial stability amid a complex and interconnected landscape.

This paper covers:

  • From LTCM to Archegos: lessons in market complexity – exploring the similarity between the two incidents.
  • Evaluating non-bank counterparties: liquidity matters – unlike traditional banks, these entities operate diverse business models, investment strategies and risk appetites.
  • Addressing correlation risk – one of the most difficult challenges in CCR management lies in assessing correlation risk, particularly between counterparties’ defaults.
  • Margin, liquidity and pricing – these factors are pivotal in ensuring robust risk management frameworks and mitigating systemic risks.
  • Tailored risk management – enhancing data collection, stress testing and scenario analysis.

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