The Joint Forum (the Basel Committee on Banking Supervision, the International Organization of Securities Commissions and the International Association of Insurance Supervisors) has published a report entitled Developments in credit risk management across sectors: current practices and recommendations.
The report provides insight into the current supervisory framework around credit risk, the state of credit risk management at firms and the implications for the supervisory and regulatory treatments of credit risk. It is based on a global survey that the Joint Forum conducted with supervisors and firms in the banking, securities and insurance sectors in order to understand the current state of credit risk management given the significant market and regulatory changes since the financial crisis in 2008.
In summary the report notes that the following themes have emerged:
- firms have improved their management of credit risk in areas such as governance and risk reporting. Risk aggregation has also become more sophisticated since the financial crisis. Firms highlighted increased reliance on stress testing using their internal models. Some supervisors have cautioned that there is a risk that some credit risk management or regulatory capital models may not adequately capture risk-taking;
- in the current low interest rate environment, there is a “search for yield” by some firms across sectors which manifests itself in an increase in firms’ risk tolerance in a variety of different products such as auto lending by banks;
- over-the-counter (OTC) derivatives, both cleared and uncleared, are a significant source of credit risk at financial institutions across sectors. As a result of both regulation and firm practices, firms are increasing the amount of initial margin they collect from trading counterparties for uncleared trades, and central counterparties (CCPs) in many jurisdictions are implementing risk management standards intended to ensure that they collect adequate financial resources from their member firms; and
- the increase in central clearing of OTC derivatives has clear benefits by reducing risk to individual counterparties, as articulated by both supervisors and firms. The consequence of this is to shift and concentrate credit risk to CCPs. Many firms have responded by increasing analysis of and reporting on CCPs.
The Joint Forum makes certain recommendations for consideration by supervisors:
- supervisors should be cautious against over-reliance on internal models for credit risk management and regulatory capital. Where appropriate, simple measures could be evaluated in conjunction with sophisticated modelling to provide a more complete picture;
- with the current low interest rate environment possibly generating a “search for yield” through a variety of mechanisms, supervisors should be cognisant of the growth of such risk-taking behaviours and the resulting need for firms to have appropriate risk management processes;
- supervisors should be aware of the growing need for high-quality liquid collateral to meet margin requirements for OTC derivatives sectors, and if any issues arise in this regard they should respond appropriately. The Joint Forum’s parent committees should consider taking appropriate steps to promote the monitoring and evaluation of the availability of such collateral in their future work while also considering the objective of reducing systemic risk and promoting central clearing through collaterisation of counterparty credit risk exposures that stems from non-centrally cleared OTC derivatives; and
- supervisors should consider whether firms are accurately capturing CCP exposures as part of their credit risk assessment.