Credit risk

New Federal Reserve Guidelines on Credit Risk Management in Transactions with Investment Funds – How to Avoid Another Archegos-like Effect

In one orientation letter published on December 10, 2021 (SR 21-19) (the “Guidance Letter”), the Federal Reserve Board reiterated the proper management of credit risk that financial institutions should consider when dealing with clients of Investment Funds. The guidance letter focuses on the appropriate identification of red flags to enable supervised financial institutions to assess the risk associated with their exposures to funds whose structure and investments may resemble an Archegos Capital scenario. Management.

Following the failure and bankruptcy of Archegos Capital Management on March 26, 2021, a leveraged fund focusing on a small number of US and Chinese tech and media companies that caused more than $ 10 billion in dollars in losses at several major banks, the Federal Reserve undertook an oversight review to assess what led to the losses suffered as a result of the Archegos bankruptcy and any consequent guidance for the banks.

In its guidance letter, the US Federal Reserve Board of Governors reminded banks of prudential expectations when holding large portfolios of derivatives and dealing with investment funds. (The advice is generally inapplicable to community banking organizations and banks with derivative portfolios or relationships with insignificant investment funds.)

The Board is particularly concerned by the situations in which, both at the creation level and during the life of the relationship when periodic credit reviews are to take place, banking organizations accept “incomplete or unverified information from the bank. share of the fund, in particular with regard to the fund’s strategy, concentrations, and relations with other market players. “A fund client with a history of concentrated positions and losses, in the opinion of the Board, raises even more important concerns The Council considers that “these practices represent insufficient due diligence and may be incompatible with safe and sound banking practices”.

At the start of a relationship as well as on an ongoing basis, supervised financial institutions are expected to “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. ”The fund’s client’s refusal to provide such information should set off red flags. supervised financial institution should consider ending the relationship, other sound risk mitigation measures, such as more stringent contractual terms, may be appropriate if they are sufficient in the circumstances. In addition, the margin terms should be adapted to clients of investment funds and must reflect sufficient risk sensitivity, allowing the financial institution to improve er his margin positions or quickly close positions if a margin call is missed.

Equally important is maintaining an effective communications framework and risk management functions. The Board reaffirmed that the risk management and control functions of supervised financial institutions [Fn1] should have “the experience and stature to effectively control the risks associated with investment funds” and that legal and business groups should review contractual terms and practices to assess whether they are sufficient and appropriate for the risk the fund poses (including reputational risk).

Although the guidance letter is consistent with the Interagency Counterparty Credit Risk Management Guidelines 2011 (SR 11-10) (the “2011 Interagency Guidance”), it draws specifically on the Federal Reserve’s review of the Archegos bankruptcy and how the losses suffered by many financial institutions could have been avoided. The guidance letter reiterates that certain practices that have allowed the risk of these losses to go unchecked would not meet the expectations of supervisors, and that supervised financial institutions are expected to undertake internal due diligence (1) as to the existence of an appropriate operational framework within the legal and business groups of the bank which enables the institution to appropriately identify and mitigate counterparty risk, and (2) with regard to specific clients in order to take fully into account the risks that the relationship may present for the bank.