A recent report published by the European Central Bank (ECB) has concluded that there is still room for improvement in how counterparty credit risk is mitigated, monitored, and managed when a counterparty is in trouble or defaults. Titled “Sound practices in counterparty credit risk governance and management”, the document presents the findings of a review conducted last year, and aims to be a reference for banks for managing counterparty credit risk.
Other areas outlined for improvement include customer due diligence procedures and stress testing frameworks. ECB suggests “taking a more conservative approach towards setting credit terms for clients failing to provide information transparently”. Furthermore, stress testing frameworks “should address not only counterparties’ credit worthiness, but also their vulnerability to specific exposure tail events”. Stress tests should “reflect a rapidly changing risk environment” and should inform decision making, including “proactive risk mitigation strategies”.
Setting good examples
Based on last year’s review, the report describes 43 sound practices observed in participating institutions. These include the presence of a three-lines-of-defence model for counterparty credit risk, adequate identification and monitoring of illiquid and concentrated positions, as well as post-default processes that ensure minimal losses and legal risks.
ECB writes that several sound practices were observed in almost all institutions, demonstrating “the sector’s ability to adapt to changing market conditions. Despite this, “there are clearly areas in which few institutions deploy sound practices, indicating the need for further efforts to enhance counterparty credit risk governance and management approaches across the industry”.
Go above and beyond
In a press release announcing the publishing of the report, ECB points out that the sound practices described “go beyond mere compliance with regulatory requirements”, but institutions are “expected to consider them when designing their approach to counterparty credit risk management”.