With the Dodd-Frank Act and Basel capital regime already imposing new requirements on derivatives players, the U.S. bank regulators added another one Tuesday completely of their own accord.
The four agencies established standards for "effective" management of counterparty risk, calling on banks to expand the role of boards in managing such risk and improve how they gauge and limit counterparty exposures.
The guidance complements swaps measures in both Dodd-Frank and the Basel framework, but was not required by either initiative. A separate rule by the regulators mandated by Dodd-Frank, for example, would set specific capital and margin requirements for certain derivatives transactions. Under Basel III, meanwhile, counterparty risk is among the factors determining a bank's risk-weighted assets when calculating its capital ratio.
But observers said the regulators have independent authority to push principles for moderating counterparty risk.
"Whereas Basel III addressed it from a capital calculation standpoint for the most part, this is meant to cover the other side of the coin which is the supervisory and risk management approach to counterparty credit risk," said Gregory Lyons, a partner at Debevoise & Plimpton LLP. "This is primarily driven by the regulators' desire to show that they're dealing not just with the numerical components of risk but also the qualitative risk management."
Counterparty credit risk has already been addressed in previous guidance from the regulators, including in a 1998 policy statement, but they said the new guidelines provide "further explanation and clarification" in light of the role counterparty exposure played in the recent crisis.
"The financial crisis of 2007-2009 revealed weaknesses in CCR management at many banking organizations, such as shortcomings in the timeliness and accuracy of exposure aggregation capabilities and inadequate measurement of correlation risks," the guidance said. "The crisis also highlighted deficiencies in the ability of banking organizations to monitor and manage counterparty exposure limits and concentration risks, ranging from poor selection of CCR metrics to inadequate system infrastructure."
The guidelines, intended mainly for banks with large derivatives books, said a bank's board should set the tone for the institution's counterparty risk appetite, and the bank should report its counterparty exposures to the board with regular frequency.
The board should also assess its counterparty risk management through an internal audit. Concentrations of counterparty credit risk should also be identified and managed, and banks with high counterparty exposure should utilize stress-testing to assess risk management.
A bank should be able to measure their counterparty exposures using various factors, including time period, in addition to the ability to calculate potential and actual counterparty exposures daily, the regulators said, "There should be sufficient flexibility to aggregate exposure at varying levels of granularity, including industries, regions, families of products … or other groupings to identify concentrations."
While Dodd-Frank created a new regulatory structure for derivatives trading, including a central clearinghouse, officials said the regulators already had powers to address certain aspects of counterparty risk.
"The origins of the [guidance] predate DFA and is the result of regulators applying the lessons learned during the crisis," said a spokesman for the Office of the Comptroller of the Currency, one of the four agencies issuing the guidelines. (The other three were the Federal Reserve Board, Federal Deposit Insurance Corp. and the Office of Thrift Supervision.)
Some said the agencies were likely trying to weigh in on the issue with principles before more prescriptive measures are completed through Basel and Dodd-Frank rulemakings.
"What this is is a statement of U.S. policy on the issue of counterparty credit risk management ahead of the curve to some extent because the international and Dodd-Frank standards are still being constructed," said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc. "It's useful because as guidance it really does begin to outline the framework the bank regulators will expect of the largest institutions and does so right now in this more consultative fashion. Guidance provides interaction in the way a flat out rule does not."
Petrou added that while the Basel committee could construct specific rules on risk management, the international capital regime has not yet delved into the issue very deeply.
"There are risk-management requirements in very broad terms in the Basel statements. … But it's not to my knowledge as detailed as what is outlined here," she said.