Capital markets

Regulators have been concerned with risks arising from significant price volatility and abrupt disruptions to market liquidity since the March 2020 “dash for cash”, following which central banks globally were forced into large-scale interventions to restore market order, including in the US Treasury market. In October, the IMF concluded that regulatory progress in dealing with these wider market issues was “lacking”.¹ Although the Financial Stability Board has since then given an update on its major policy programme, which includes its response to the role of NBFIs in the “dash for cash”, the recommendations remain general, and it will be several years before any final policy frameworks are agreed and regulators enact them.

While these instances of market instability are new in their nature and magnitude, some supervisors are concerned that their origins lie in firms’ failing to learn from the Great Financial Crisis and embed the necessary changes to business and risk management practices in their operations. Other, idiosyncratic events - such as the collapse of Archegos and the disruption to the UK gilts market last autumn - amplify such concerns.

In November, the Bank of England highlighted a range of issues related to banks’ interactions with NBFIs² – beginning with banks’ failure to understand their clients’ overall leverage (which left some banks overexposed to Archegos). It also highlighted the need for banks, alongside NBFIs, to improve the quality of their stress testing to incorporate non-normal events (such as an unprecedented rise in yields which triggered the liability-driven investment (LDI) related stresses in the UK gilts market). Lastly, it specified that banks must adopt a “laser like focus on wrong-way risk”³ (which could have helped mitigate the impact of the UK gilt price spirals that exacerbated the LDI crisis).

We see these concerns leading supervisors to focus on three separate, but related, issues: firms’ counterparty credit risk management frameworks; margining practices, including collateral management; and the effectiveness of firms’ booking model controls and risk management. Given the absence of concerted global action in relation to NBFIs and the significant presence in some markets of unregulated participants, we expect national supervisors to focus most on investment banks and prime brokers over which they can exercise direct authority.

On counterparty credit risk management, the PRA has already indicated that it expects firms to assess risk concentrations not only on an individual client basis, but across all clients combined and, most importantly, across each client’s market-wide portfolio. This will require firms to collect significantly more data than they do at present, while their ability to do so will, in part, depend on counterparties’ willingness to provide it.

Market participants’ ability to meet margin requirements has been tested, and in some cases, found wanting during periods of significant market volatility. In the short term we expect this to result in supervisors scrutinising the ability of all types of regulated firms to manage their margin requirements, modelling collateral inflows and outflows under a range of scenarios, and testing their ability to mobilise collateral to meet margin calls under normal and stressed conditions. Supervisors have clearly been surprised by some firms’ apparent unpreparedness for large collateral outflows and want to make sure that they learn lessons from this episode in advance of the next one. 

These actions by supervisors to batten down the hatches after market instability align with their ongoing drive for banks to simplify their booking arrangements and strengthen related governance and risk management frameworks, improving resilience to any further disruption.

This has been visible for some time in the PRA’s and ECB’s evolving expectations and is therefore not a new topic on the supervisory agenda. However, recent scrutiny has forced some banks to invest significantly to improve their approaches in these areas, and has in turn raised supervisory expectations for all banks. Despite some banks having made real progress, supervisors continue to find that others still too often operate with complexities arising from historic acquisitions, tax structures and legacy booking arrangements. As a result, we do not expect any reduction of supervisory vigilance in this area.

Both the ECB and PRA have conducted major thematic reviews in recent years on banks’ booking arrangements. The ECB, through its recent desk mapping review, is continuing with investigations into firms’ risk-shifting techniques and reliance on other group entities. Although we expect the findings of this review to be taken forward on a bank-by-bank basis, it is likely to drive further changes to booking models for large banks. In the UK, the PRA continues to ask banks to complete self-assessments against its current expectations - particularly around controls, senior manager accountability, risk oversight and management information. Most notably, banks still find it challenging to meet basic supervisory expectations, such as ensuring booking arrangements are transparent, permissible or “intended” transactions are clearly defined, and they establish an appropriate balance of preventative and detective controls to ensure adherence to their policies. 

Meanwhile recent market volatility and the rising interest rate environment mean that interest rate risk management is a key priority for banks. Banks are focussing on reviewing Interest Rate Risk in the Banking Book (IRRBB) assessments to identify interest rate risk positions and considering the impact of hedging strategies on the balance sheet, while also assessing the trade-off between earnings’ stability and capital volatility. 

In the EU, supervisory focus on individual capital markets firms has been complemented by two important developments in relation to market structure and infrastructure. The first concerns the European Commission’s final European Market Infrastructure Regulation proposal to require EU based firms subject to the clearing obligation to maintain an “active” account at an EU Central Counterparty (CCP), although the Commission proposes to entrust the European Securities and Markets Authority (ESMA) with defining “active”. In parallel, through proposed changes to the Capital Requirements Directive and Investment Firms Directive, firms will be required to produce plans to meet this new requirement and competent authorities empowered to take action where they fall short. The ultimate aim is to reduce the EU’s reliance on systemically important clearing services provided by UK CCPs substantially.

The second relates to EU policymakers’ intent to future-proof their energy derivatives markets in the wake of price volatility that took European gas prices as high as 1500% of their long-term average. Foremostly, the European Commission has tasked the European Agency for the Cooperation of Energy Regulators (ACER) with the development of a new Liquified Natural Gas (LNG) benchmark by 31 March 2023 which reflects the price of LNG more accurately than the existing TTF benchmark and is expected to result in lower prices. However, new benchmarks generally take years to underpin a material number of derivatives contracts.

In this potentially long interim period, the new benchmark will split LNG derivative liquidity with its predecessor – potentially making derivatives pricing even more susceptible to the underlying fundamentals of volatile European energy prices. Given the wild swings in price, ESMA, ACER and national competent authorities (NCAs) have stepped up their supervision of “possible market manipulation and abuse” in energy derivatives markets.⁵ Notwithstanding the view expressed by the Dutch Financial Markets Authority that “there has been no sign of manipulation or excess speculation despite the sharp price rise of LNG”,⁶ we expect that ESMA and NCAs will be particularly vigilant for evidence of possible market manipulation and that market participants will receive requests for additional information when the supervisors identify unusual trading patterns. 

All firms

• Focus on increasing the due diligence undertaken to understand their counterparties’ ability to meet margin calls, including whether they set initial margin at sufficiently robust levels.
• Prepare for financial stability authorities to carry out stress tests to identify emerging market-wide vulnerabilities and whether and how NBFIs contribute to them.
• Spend time understanding the scope of the European Commission’s proposed changes to derivatives clearing and how these will affect their business models and strategies. Monitor how the proposals develop as they progress through the EU’s legislative machinery, although it will be difficult to assess the full impact of the proposal until ESMA has completed its work to define an “active” account.

Banks

• Demonstrate significant progress in improving their ability to detect counterparty risk concentrations, at various levels: individual counterparties; across all counterparties combined; and at the level of an individual client’s market-wide portfolio.
• Simplify booking model – considering the number of booking entities and the nature of intra-group relationships that exist between the most significant of them. This needs to be done in a joined-up manner, overcoming natural operational siloes where different functions across the organisation aim to optimise to different constraints (capital, tax, funding, operating costs).
• Review risk management and control infrastructure for booking arrangements – especially preventative controls to mitigate the risk of impermissible transactions, operational booking errors or breaches of legal entity risk appetite. Consider the business case for using emerging third-party technology solutions that enable preventative controls drawing on digitised regulatory rule-sets and decision engines.
• Review behavioural assumptions applied in interest rate risk modelling for key areas such as prepayment risk, non-maturing deposits and early redemption of term deposits.
• Ensure a clear understanding of the way in which increasing interest rates affect the calibration and outcomes of IRRBB models. Treasury and risk functions should challenge and revise IRRBB model assumptions to ensure they properly capture interest rate risk, including further scenario and sensitivity analysis.

Fund managers

• Establish that their stress tests are sufficiently severe, their fund redemption terms are adequately aligned to the liquidity of the underlying assets and that the quality of the data they use for fund stress testing and liquidity management is as robust as it can be.