ECB urges lenders to fix risks in trades with hedge funds and family firms

The European Central Bank has warned Europe’s lenders they will face regulatory intervention unless they urgently fix “material shortcomings” in managing risks from trading counterparties such as hedge funds, family firms and commodity traders.

The ECB’s supervisory chief Andrea Enria delivered the warning in a blog post outlining counterparty credit risks, calling on them to make a range of improvements such as implementing better stress-testing exposures to shadow banks, relying less on the discretion of individual desks, and introducing other safeguards.

The ECB’s call reflects growing regulatory unease about the potential for contagion after the implosion of family office Archegos in late 2021 revealed gaping weaknesses in the counterparty risk management of banks’ capital markets operations. The Bank of England on Tuesday wrote to its leading lenders, criticising them for not doing enough to mitigate risks in their dealings with non-bank financial institutions.

Despite publishing guidance on better practices in August, Enria said there were still “material shortcomings” in the operations of the 23 eurozone banks the ECB focused on because they are most active in the derivatives and securities financing markets with non-bank financial institutions.

“Institutions need to go beyond mere compliance with regulatory requirements when designing their approaches, which should be proportionate to the scale and complexity of the business, products offered and the nature of the counterparties,” Enria wrote in the post published on Friday, adding that institutions also need systems that can “keep pace with the increasingly fast-moving and complex market situation”.

The ECB made a series of recommendations about how banks can better manage risks with their trading counterparties, which use banks so they can amplify their bets on equities, bonds, commodities and derivatives.

The ECB wants banks to enhance their due diligence, including considering a client’s failure to disclose information as a red flag that would lead to a more “conservative” approach to how much credit the client was extended “or even rejection or offboarding of clients”.

Enria also wants banks that have big exposures to trading counterparties to be more explicit about their approach to each relationship by setting it out clearly in a risk appetite statement. There should be bank-wide processes for dealing with counterparties in trouble, rather than ad hoc measures which at times led to legal terms “being relaxed under commercial pressure”, he added.

The supervisory chief also called for better stress-testing and monitoring of trading counterparty risks, particularly those relating to non-bank financial institutions like family offices, hedge funds, insurers and private equity firms.

Enria said his supervisors would visit some banks’ offices this year to make sure they were complying with the ECB’s expectations and would “use the full spectrum of supervisory tools to ensure that supervised banks promptly address weaknesses in their risk management frameworks”.

Global regulators are also stepping up efforts to directly regulate non-bank financial institutions, which have had looser oversight than banks and now account for almost half of global financial assets, according to a December 2022 report from the Financial Stability Board.