In recent years, regulatory scrutiny over banks’ resolution plans has intensified to ensure they can be dismantled without posing systemic risks during financial distress. A key component of these plans involves accurately calculating resolution liquidity and capital needs (RLEN and RCEN). However, several major banks have faced challenges in this area. Notably, a recent miscalculation by Citi has drawn significant attention and concern from both regulators and industry observers.
The Federal Reserve’s review of Citi’s resolution plan highlighted deficiencies in the ability to properly simulate the unwind of its derivatives portfolio properly. This miscalculation stems from an inability to view derivatives positions at a counterparty level within both the portfolio unwind and segmentation capabilities. Such a shortcoming is particularly alarming as it suggests systemic issues within the data management and risk assessment practices.
Managing derivatives: the role of the XVA desk
Effectively managing derivatives is paramount for any bank, especially during periods of market stress. The XVA (valuation adjustment) desk plays a crucial role in managing these positions by collecting all derivatives data across various portfolios and aggregating them by counterparties. This aggregation is essential for accurately assessing counterparty risk and determining the credit valuation adjustment (CVA), which reflects the potential loss due to a counterparty’s default.
Consequences of inaccurate CVA and collateralisation
A failure in this aspect means that in the event of a counterparty’s default, banks would struggle to promptly account for all associated losses. This could lead to severe financial repercussions and undermine confidence in the bank’s risk management capabilities. Furthermore, the accuracy of the CVA, which hinges on the aggregation and proper collateralisation of derivatives with each counterparty, would be compromised. Without a precise view of these positions, banks cannot ensure that appropriate collateral is posted, leaving them exposed to heightened risk.
Regulators have not taken these deficiencies lightly. The Fed has mandated that Citi rectify these issues in its 2025 resolution plan. The directive underscores the critical nature of robust data management and risk aggregation practices, particularly for large and interconnected institutions. Ensuring the ability to view and manage derivatives at a counterparty level is not just a technical requirement but a fundamental aspect of sound risk management and financial stability.
Current practices and siloed functions in banks
In some banks, the function responsible for RCEN/RLEN outputs does not even use an XVA solution, resulting in an inability to view derivatives positions at a counterparty level. When asked why, the most common response is that the necessary data integrity and associated RCEN/RLEN outputs are managed by a different part of the bank, not the XVA desk within the Markets business. Given the siloed nature of some banks’ functions, this approach may seem reasonable. However, regulators believe that if one group within the bank can assist with a task where another group fails, then collaboration should occur. Connecting to the XVA solution should be included in banks’ plans and implemented as part of the 2025 plan submission.
As financial markets evolve and the complexity of financial instruments grows, the ability to aggregate and analyse data across all dimensions of a bank’s operations becomes increasingly vital.
Advanced technology
To address these challenges, banks are turning to advanced technology providers, such as Quantifi, that deliver a single solution, enterprise wide, across all asset classes. These solutions allow banks to price and obtain sensitivities for all products and then distribute aggregated metrics across counterparties. This capability is crucial for accurately assessing and managing counterparty risk. Moreover, Quantifi’s front office and risk prices are consistent, eliminating the need for reconciliation between these functions. This enhances the accuracy and reliability of risk assessments and financial reporting.
Quantifi’s unified approach helps banks overcome the limitations of fragmented solutions that struggle to provide a comprehensive view of derivatives positions. By enabling the aggregation and analysis of data across various dimensions, Quantifi supports better-informed decision-making and more effective risk management.
As financial markets evolve and the complexity of financial instruments grows, the ability to aggregate and analyse data across all dimensions of a bank’s operations becomes increasingly vital. Banks must invest in advanced data management technologies and risk assessment frameworks to meet regulatory expectations and safeguard their financial health.
Lessons learned and the path forward
In conclusion, challenges with calculating RLEN and RCEN due to failures in derivatives management highlight significant vulnerabilities in resolution planning processes. The inability to view derivatives positions at a counterparty level undermines risk management practices, potentially exposing banks to significant financial risks in times of stress. Regulatory mandates for improvement underscore the critical importance of robust data management and risk aggregation capabilities. As banks work to address these issues, the industry at large must heed this cautionary tale and ensure their solutions are up to the task of managing the complexities of modern financial markets.
Quantifi’s XVA solution
You need the ability to verify pricing and understand the risk of your derivative business. Achieve pricing certainty and understand your risk with Quantifi’s integrated counterparty credit risk and XVA solution. Market-leading models deliver accurate results for all XVA measures and economic capital. Become confident in your trading and risk management.