The Fed’s Vice Chair for Supervision, Michael S. Barr, has outlined four key priorities for firms looking to sure-up their counterparty credit risk management.
In a speech delivered this week, Barr argued interconnectedness among large financial institutions can propagate systemic risk. He explains, “Shocks can rapidly propagate throughout the financial system along these interconnections, rather than being isolated or dampened.”
He says that if major counterparties fail to manage risk appropriately at the firm level, government intervention can be required to prevent broader collapse.
To address these concerns, Barr outlines four priorities for enhancing the resilience of the core financial system:
1) Improving Transparency
Barr argues that greater transparency into firms’ counterparty credit risk exposures is critical. Specific recommendations include improving reporting frequency, granularity, and inter-affiliate transparency. More robust disclosure to the public on gross derivatives and SFT exposures will also help markets discipline risky build-ups.
2) Enhancing Stress Testing
In terms of stress testing, Barr says firms need to better incorporate unlikely but very severe shocks into their credit exposure models and internal capital planning. This includes accounting for multiple counterparties failing simultaneously and for vulnerabilities from cross-margining programs and central clearinghouses.
3) Coordinating Regulatory Policies
Barr called for global regulators to work closer to ensure margin, collateral, and central clearing policies limit the chances for regulatory arbitrage. He said that cross-border fragmentation of policies governing derivatives and intra-group booking of trades remains a core challenge. Barr also maintained that dialogue through BCBS and FSB remained positive.
4) Improving Supervisory Data
Finally, Barr admitted regulators must keep working to address data gaps to see a build-up of exposures on a market-wide basis. He argues that access to more granular, high-frequency data on derivatives and SFT trades is necessary to enable macroprudential oversight. Trade repositories and leveraging technology can help overcome current limitations.
While regulations have expanded since the 2008 global financial crisis, risks from securities financing transactions and derivatives remain an “important source of systemic risk,” Barr said. Ongoing oversight and coordination of counterparty risk management internationally remains essential for stability.
