Counterparty credit risk management

The PRA highlights the expansion of UK banks' and international banks' operations in the financing of the UK PE sector as the value of AUM has grown. In particular, the PRA notes an increase in exposures to 'non-traditional' forms of financing linked to financial sponsors and the PE fund sector, such as Net Asset Value (NAV)-based loans secured against PE fund assets and facilities backed by Limited Partner (LP) interests. It also observes that there have been structural changes, such as the growth of private credit markets and consolidation as some investment banks exit prime broker services, including those providing subscription financing credit facilities to PE funds.

Banks can hold exposures to the same PE firms in different business lines, sometimes in separate parts of the group. At the heart of the PRA's concerns is the potential for these exposures to be significant, have complex interlinkages and for the valuation of collateral underpinning them to be difficult.

Given these developments and ongoing global economic uncertainties, the PRA carried out a thematic review of banks' private equity-related financing activities, including derivatives exposures. The PRA's review focused on independent credit and counterparty credit risk management (CCRM) processes that support the overall expansion in PE-related financing and hedging activities.

The main finding of the review was that many banks did not have a comprehensive risk framework to monitor and control their specific combined exposure to particular PE firms. This led to other findings — that banks were not able to stress test their exposures comprehensively and that boards did not have good oversight of PE-related exposures and risks. The PRA notes that this is not surprising given the growth of the market but it is disappointed, especially as it highlighted similar issues in letters after the default of Archegos Capital Management and its thematic review into fixed income financing.

The key findings of the review relate to:

Data aggregation and a holistic approach to risk management

Some banks were unable systematically to identify and measure combined PE sector credit and counterparty exposures within their overall risk data because of alignment of counterparty credit risk management processes to product lines or industry sectors without a method to provide an overarching view.

They were also unable to calculate comprehensive consolidated exposure data to measure and control combined PE credit and counterparty risks linked either directly or indirectly to individual financial sponsors. Often, there was no risk appetite framework to constrain the size of aggregate PE exposures linked to individual financial sponsors.

The PRA expects banks systematically to flag all transaction and exposure data together with relevant collateral pledges that relate to the PE sector in their trade capture and risk management systems. This should enable risk managers to identify and consolidate relevant counterparty and credit risk exposure information. Banks should ensure that such data aggregation capabilities enable them to calculate and monitor exposures to the PE sector overall, as well as exposures linked to individual financial sponsors and individual PE funds.

This requirement is not new, with the PRA referencing the 2013 BCBS Principles for effective risk data aggregation and risk reporting (BCBS 239), and expectations published by it and the FCA following the default of Archegos Capital Management.

Credit and counterparty risk interlinkages

Banks did not have independent credit and CCRM procedures in place to identify, measure, combine, and record risks that arise from all overlapping financial claims, liens and security interests that have direct or indirect linkages to the same underlying PE fund or related portfolio company.

The PRA expects credit due diligence procedures and management information processes to recognise and measure the presence of overlapping credit exposures, collateral pledges, and financial claims across all PE-related activities where performance and recovery values of such amounts are interlinked.

Stress testing

Banks performed stress tests solely in the context of individual business unit portfolios or product silos and did not consider the results of these scenarios in aggregate. This is partly related to the issues highlighted around data aggregation — a holistic stress test is difficult to perform in the absence of holistic data.

As banks' exposures to PE funds increase, the PRA expects them to evaluate the potential for higher than previously observed default and loss correlations in periods of stress:

• Analysis should apply to all types of direct and indirect exposures connected to individual financial sponsors as well as to the PE sector overall. 
• Stress tests should be modular and tailored to the idiosyncratic risk profile of different products and structures. 
• Banks should consider theoretical scenarios and potential loss outcomes that do not conform solely to historic default rates or previously observed risk and performance correlations associated with individual products, underlying obligors, and clients. 
• Scenario results should be aggregated and allocated to individual financial sponsors and their PE funds.
• Information should be systematically used by independent credit and CCRM functions in assessing the size and composition of overall PE linked financing activities and related derivatives exposures, as well as the appropriateness of exposures linked to individual financial sponsors.

Board level reporting

Banks' boards were not specifically informed of the overall scale of aggregate exposures linked to the PE sector or to individual financial sponsors. As a result, they had not conducted a holistic assessment of the risks.

Boards should be informed of the aggregate exposures linked to the PE sector and consider the overall business strategy of the group in relation to consolidated PE-linked activities. Boards should satisfy themselves that the scale and composition of risk exposures linked to material financial sponsor clients, and the PE sector in general, is appropriate in the context of the overall risk profile of the bank.

CROs, to whom the letter was addressed, need to review and assess the PRA's findings and expectations against their current practices. They also need to share the output of the benchmarking exercise with their Board Risk Committee and provide this analysis, together with detailed remediation plans to their PRA supervision team by 30 August 2024.

However, the overall themes and expectations from the PRA are not new and should not only be considered in the context of private equity financing. The PRA's January 2024 supervisory priorities letter to international banks noted that some firms still consider risk management in silos, without considering the read-across to all businesses lines and sectors. 

Similar themes have also been raised by ECB Supervision in its 'Sound practices in counterparty credit risk governance and management' and 'Supervisory expectations for prime brokerage services'.  

To facilitate the aggregation of counterparty risk across business lines banks should start at the foundations — the data, and ask whether:

• Trade capture data is in a format that allows the identification of linked counterparties and the comparison of different types of exposures.
• The data can be aggregated in one system to enable production of timely management information. 
• The data can be used to explain exposures to boards and enable them to set overall risk appetites and monitor against it.
• All the exposures to a particular counterparty can be aggregated and measured quickly if that counterparty starts to show signs of distress. 

Once the relevant data has been gathered, banks should also consider:

• Liquidity of private assets — as private asset positions are often illiquid, it is essential that banks have a clear strategy for winding down or exiting such positions under stress.  
• External concentration risk — where similar exposures are held by multiple banks, as happened in the case of Archegos, the effect of market moves can be compounded when they all try to liquidate their positions. Regulators have suggested that banks should be able to identify such risks and put in place additional limits and margins to mitigate them.

As markets continue to be volatile and financing conditions tighten, private equity firms may need to increase their leverage, potentially exposing banks to increased credit and counterparty credit risk. 

To discuss the implications of the PRA review for your business, or to talk with our regulatory, credit/counterparty credit risk or balance sheet optimisation professionals, please contact us.