Board of Governors of the Federal Reserve System

Overview

Events in both emerging and developed financial markets over the past two years and their negative impact on some banking institutions have underscored to both banks and bank supervisors the challenges involved in adapting existing risk management tools to new products, customers, and product lines in increasingly global and interrelated markets. Losses stemming from the Asian crisis and the 1998 market turbulence, including those arising from bank hedge fund relationships, indicate that basic credit risk management policies, procedures, and internal controls were insufficient at some institutions to address the risks of new, fast growing, or evolving products and activities.

Going forward, banking institutions must remain acutely mindful of the need to focus sufficient resources and attention on ensuring the integrity and adequacy of all elements of their counterparty credit risk management processes. This is especially true for activities, business lines, and products experiencing significant growth, above normal profitability or risk profiles, and large potential future exposures.

To address weaknesses in risk management systems, the Federal Reserve is issuing the attached guidance providing supervisors and bank management insights on those elements of counterparty credit risk management systems at large complex banking organizations that may need special review and enhancement. (Refer to Attachment I.) The guidance reiterates and expands upon fundamental principles of counterparty credit risk management that are covered in existing supervisory materials of the Federal Reserve and other regulators and in established industry standards.¹

As further detailed in the attached guidance, examiners and supervisory staff are instructed to continue and, where appropriate, strengthen their efforts to evaluate whether banking institutions:

• Devote sufficient resources and adequate attention to the management of the risks involved in growing, highly profitable or potentially high-risk activities and product lines.

• Have internal audit and independent risk management functions that adequately focus on growth, profitability, and risk criteria in targeting their reviews.

• Achieve an appropriate balance among all elements of credit risk management, including both qualitative and quantitative assessments of counterparty creditworthiness; measurement and evaluation of both on- and off- balance sheet exposures, including potential future exposure; adequate stress testing; reliance on collateral and other credit enhancements; and the monitoring of exposures against meaningful limits.

• Employ policies that are sufficiently calibrated to the risk profiles of particular types of counterparties and instruments to ensure adequate credit risk assessment, exposure measurement, limit setting, and use of credit enhancements.

• Ensure that that actual business practices conform with stated policies and their intent.

• Are moving in a timely fashion to enhance their measurement of counterparty credit risk exposures, including the refinement of potential future exposure measures and the establishment of stress testing methodologies that better incorporate the interaction of market and credit risks.

To adequately evaluate these factors, supervisors and examiners should conduct sufficient and targeted transaction testing on activities, business lines, and products experiencing significant growth, above normal profitability or large potential future exposures.

Challenges in Adapting Existing Risk Management Tools to New Activities and Product Lines

Current supervisory guidance as well as various industry studies and reports have long identified the principal elements of sound counterparty credit risk management. These elements are:  (1) an adequate assessment of the creditworthiness of a counterparty, both initially and on an ongoing basis; (2) adequate risk measurement; (3) the use of effectively designed credit enhancements; and (4) a robust system of monitoring and controlling exposures against limits. The "tools" needed to successfully implement each of these elements include the information used to make assessments of creditworthiness, the collateral and contractual closeout arrangements used to enhance credit relationships, the measures of potential future exposure and current market value used to monitor risk, and the limits used to manage exposures and initiate risk controlling actions.

As financial institutions develop new product lines, customers, and businesses, they often utilize these tools in forms that have evolved in the context of more established business lines. Moreover, conventional wisdom, experience, and common practice can often result in certain tools being used more prominently than others, leading to imbalances in the overall credit risk management process. For example, heavy reliance on collateral or counterparty reputation may reduce incentives to make potentially costly enhancements to credit exposure measurement systems. This over-reliance on certain tools, at the expense of a more balanced approach, may not create significant risk management problems when the volume of new products, customers or businesses is low. However, once the volume of these new activities expands beyond a critical mass, such imbalances can often lead to serious credit risk management shortcomings. This is a particular concern in those cases where new and growing activities reach a level where stress events, which often involve the suspension of long-standing and widely accepted relationships among markets and risk factors, can result in material financial loss.

Clearly, recent events in both emerging and developed financial markets have illustrated that risk management systems broke down in some product, customer, and business lines that experienced significant growth and above normal initial profitability. In these cases, competition, pursuit of earnings, and the general press of business appear to have resulted in the introduction of risk exposures for which existing risk management infrastructures were not sufficient. For example, in the case of the 1997 Asian crisis, over-reliance on implied sovereign guarantees may have led many financial institutions to pay less attention to the financial condition of individual foreign counterparties. Similarly, in the case of hedge funds, over-reliance on the use of collateral and counterparty reputation may have led to compromises in the due diligence process or in the adequate measurement of credit exposures.

Potential Weaknesses in Credit Risk Management Systems

Supervisory experience at the international level and the findings of supervisory reviews have identified weaknesses in the policies, practices, and internal controls of the counterparty credit risk management systems at some large banking organizations. In some cases, policies governing certain elements appear unduly general so as to compromise their usefulness in managing the risks involved with particular types of counterparties. In other areas, practices may not conform to stated policies or their intent. Situations may also exist where internal controls, including documentation and independent review, are inadequate or lack rigor. In addition, some large institutions have credit risk exposure measurement and management regimes that, while effective in traditional areas of bank credit extension, need enhancements when employed in more sophisticated or complex trading and derivatives activities.

The attached guidance identifies specific areas that supervisory staff and bank management should consider in assessing and strengthening the credit risk management processes in trading and derivatives operations. In particular, it offers important insights as to how some banks' counterparty credit risk management systems may need to be enhanced in consideration of:  (1) the specific types of counterparties with which they do business; (2) current industry practices that may emphasize certain elements of risk management over other elements; and, (3) the increasingly important interactions between the market and credit risks involved in banks' trading and derivatives relationships.

The guidance is forward looking and applies to the management of exposures arising from the broad array of current and future bank counterparties and counterparty types. The guidance is particularly relevant in light of work conducted by the Basle Committee on Banking Supervision (BCBS) regarding bank relationships with "highly leveraged institutions." That effort has provided an excellent case study that details, in the context of a specific type of counterparty, the consequences and implications of inadequacies in some banking organizations' counterparty credit risk management systems.² Documents resulting from that international supervisory effort are available through the Bank for International Settlements Internet site at www.bis.org.³

As necessary, the specific insights offered in the attached guidance as well as those provided in the BCBS documents will be formally included in the Federal Reserve's Trading and Capital Markets Activities Manual in its March 1999 update.

Reserve Banks should ensure that all supervisory central points of contact, examiners, and other staff involved in the supervision of large complex banking organizations review this guidance and focus their supervisory efforts accordingly. Reserve Banks should also distribute this guidance to domestic and foreign banking organizations with significant trading and derivatives counterparty credit exposures. A draft transmittal letter is provided in Attachment II. Supervisory staff involved in the supervision of institutions with hedge fund counterparty relationships should also review the BCBS documents.

Questions regarding this guidance should be directed to Michael Martinson, Deputy Associate Director, Specialized Activities, (202-452-3640) or James Embersit, Manager, Capital Markets, (202-452-5249).

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