(Bloomberg) -- UK regulators are examining the policies banks use when deciding how much margin to demand from clients as they look to avoid another incident like the implosion of Archegos Capital Management, which cost the industry billions of dollars and plunged Credit Suisse into a crisis that ultimately led to its collapse.
The Bank of England is trying to understand how clients’ willingness to share their full list of market positions could affect banks’ margin decisions, according to Nathanaël Benjamin, executive director of financial stability strategy and risk at the central bank. Banks that require too little collateral from the clients they provide leverage to can undermine financial stability, he said.
At the heart of regulators’ concern is a shift in risk-taking from banks to non-banks since the global financial crisis. The BOE’s latest scrutiny comes as it probes more than 50 financial market participants — including large banks, insurers, central counterparties, hedge funds and other asset managers. It’s the latest round of its system-wide exploratory scenario, which is designed to improve the central bank’s understanding of how banks and non-banks behave in stressed conditions.
“Getting margin and haircut levels and practices right is crucial for financial stability,” Benjamin said at an International Swaps and Derivatives Association event in London. “This requires a high degree of transparency, effective stress testing, and improvements to operational processes.”
The central bank announced the results of the first phase of the war games last month and is planning to publish a final report on the exercise by the end of this year.
The BOE’s Prudential Regulatory Authority has already told lenders that their risk management division should own the process for setting haircuts, which is a measure of the difference between an asset’s market value and the amount that a bank would allow that asset to be used as for collateral.
The Basel Committee on Banking Supervision is also considering proposals that are meant to improve banks’ risk management of counterparties, including how lenders should adjust their risk appetite when a counterparty refuses to provide adequate disclosures about their risk.
Benjamin said it would be preferable for banks to come up with their own solutions to tame excessive leverage in the financial system rather than regulators imposing mandatory policies for haircuts. However, he said, “if the market proves unable, then we won’t hesitate to do what needs to be done.”
The moves come as Archegos founder Bill Hwang was found guilty of criminal charges earlier this month stemming from his firm’s 2021 collapse, which stunned the financial community and saddled counterparties with $10 billion in losses. The massive losses suffered by the banks raised serious questions about how they assessed the risks of taking on and extending credit to trading clients.
“Had margins and haircuts been higher in good times, market participants may have maintained a more robust buffer against contagion risks in the market, acting as a first line of defense against the risk they chose to take on,” Benjamin said Thursday. In addition to the Archegos saga, he also mentioned a bevy of recent other market disruptions, including the rout in UK bonds sparked by leveraged pension fund strategies in 2022.
Financial institutions must “continue to improve their own risk management frameworks so that they adequately consider the exposures of their clients and counterparties,” he said, noting banks often offer initial margin terms in some derivatives markets, or haircuts in repo markets, based on commercial incentives rather than risk considerations.
“Enhancing market participants’ liquidity preparedness to meet their collateral requests would go a long way towards reducing pro-cyclical behaviors in response to large margin calls and preventing the liquidity crises that have amplified past financial shocks,” Benjamin said.
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