If you thought banks had their act together with regard to assessing counterparty risk in the derivatives markets, you would be wrong. According to a report from the Senior Supervisors Group (SSG), a global watchdog headed by the Federal Reserve Bank of New York’s Sarah Dahlgren, large banks are still unprepared to deal with market disruption and risk-management issues that crop up in the over-the-counter derivatives markets.
“Our observations in this report indicate that firms’ progress toward consistent, timely and accurate reporting of top counterparty exposures fails to meet supervisory expectations as well as industry self-identified best practices,” Dahlgren wrote in the report’s cover letter. As a result, if a financial institution were to be on the brink of collapse, many large banks would still be highly vulnerable to contagion risk.
Writing in The Wall Street Journal on Monday, Francesco Guerrera pointed out that the SSG was established to fix a problem that arose during the financial crisis: “Banks and their supervisors didn’t have enough information to consistently and accurately know who the counterparties were on trillions of dollars in derivatives contracts.” In other words, in a period of financial stress, finding who is on the other side of a bileratal derivatives deal “is [still] like looking for a needle in a haystack at night with a candle.”
The SSG program forces 19 large, global banks to regularly report their top 50 counterparty exposures, and the requirement has led to some improvement in practices and systems. Thirteen of the 19 banks, for example, “managed to report weekly data on derivatives contracts to a central database within three days” in 2012, according to the WSJ. But five European Union banks could not meet the three-day deadline, and two EU banks could report on exposures only biweekly or monthly, “at substantial lags,” said the SSG.
In addition, while banks improved the ability to capture exposures by business line and corporate parent, many had trouble reporting key metrics like credit valuation adjustment (CVA), defined as the market value of counterparty credit risk. Less than half of the banks were able to report CVA weekly.
In addition, since the SSG first started collecting data in 2010, data-quality standards have declined, which the group attributed in part to “breakdowns in controls and governance procedures.” For example, the SGG said that in 2012 two U.S. banks “reverted to providing poorer data than in previous years — primarily due to turnover in the areas producing the report, which led to lapses in [the banks'] quality controls.”
The U.S. banks participating in the SSG project include Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo. EU financial institutions participating include BNP Paribas, Deutsche Bank and Banco Santander.