Risk management practices: 5 areas of focus for Financial Market Infrastructures (FMIs)

The Covid-19 pandemic triggered an unprecedented macroeconomic shock that impacted the global financial system. The resulting market turmoil, together with significant spikes in volatility and trading activity, presented particular challenges to the design and the resilience of risk management in Financial Market Infrastructures (FMIs).

by Adrien Vanderlinden, Executive Director, Systemic Risk Office, DTCC

With the benefit of hindsight, FMIs around the world have successfully navigated this real-life test. That said, these events have also highlighted 5 focus areas for FMIs and their participants to proactively manage risk in a post-pandemic environment.

Risk model performance

First, it should be recognised that the market stress that emerged as the pandemic started to spread strained the ability of certain risk models that are based on historical data to produce reliable output. That said, models designed to function in ‘normal’ markets should not be discarded simply because they have limitations in extreme market circumstances. Instead, what this episode illustrates is a well-known fact that is not new by any standard: FMIs should have the requisite model performance monitoring, strategies, and governance in place to identify and address emerging model risk issues on an ongoing basis.

Margin procyclicality

Second, while margin procyclicality was already a topic of debate prior to the pandemic, the extreme market volatility we saw in March and April 2020 will likely make the issue much more prominent going forward. The most important goal for CCPs (central clearing counterparties) is to make sure that they collect enough margin to protect their members, underlying investors, and themselves in times of stress. It is also important to note that risk-based margining methodologies are naturally procyclical, as they tend to generate increased margin requirements during times of market volatility, which in itself is not inherently problematic. A potential mitigant is education so that FMI members are sufficiently prepared to anticipate the impact of volatility spikes and clearing activity changes on their margin requirements. As such, FMIs must further promote margin transparency through the continued availability of tools that allow their members to understand risk models and estimate margin requirements under a wide range of circumstances.

Sector-specific approach to managing credit risk

Third, FMIs need to take a more sector-specific approach to managing credit risk due to the significant divergence of pandemic recovery prospects across corporate sectors, geographies, and other variables. A key consideration is the extent to which banks and other financial institutions are exposed to sectors that have been particularly adversely impacted by the pandemic, such as travel and leisure. As a result, credit risk assessments need to include a sector-specific review, with a focus on firms with the greatest concentration of risk. In the banking sector, additional indicators of risk can be found by analysing stress test results, as well as reviewing macroeconomic and loan delinquency data released by various sources, such as the Federal Reserve and credit reporting agencies.

Continuous assessment of FMI members’ available liquidity

Fourth, given the spikes in volatility, trading volumes and margin calls, FMIs should continue to closely monitor clearing members’ financial resources, in particular available liquidity, on an ongoing basis, as this can change quickly in a crisis. Financial firms face trade-offs between maximizing profitability and ensuring they have access to sufficient financial resources in a crisis. While retaining surplus capital or maintaining sources of liquidity may appear suboptimal from a capital usage and profitability perspective, it can be crucial to surviving a crisis. FMIs must assess how their members balance these trade-offs and whether they have allocated sufficient resources for normal times, mildly stressful circumstances, and extreme events, such as the Covid-19 pandemic.

Impact of remote working on operational risk

Finally, FMIs must consider that remote work can create new operational risks that need to be managed on an ongoing basis. FMIs successfully transitioned their workforces during the early stages of the pandemic without material impact to services thanks to well-planned risk management strategies, as well as significant pre-pandemic investments in business continuity planning and supporting technological capabilities. An extended remote work environment and the development of return-to-office plans that may involve a change in staffing models will require developing and implementing new capabilities that support the identification, monitoring and managing of associated risks. Further, the growth of remote work in the future may create additional cyber security vulnerabilities that must be monitored and integrated into existing cyber risk management frameworks. FMIs will also need to evaluate strategies and controls to mitigate the operational risks created by a potential outage related to a critical third party.

The impact of the pandemic on financial markets created a real-life stress test for risk models as margins surged amid spikes in volatility. FMIs around the world clearly met this challenge, helping to safeguard global financial stability. While their robust financial risk management frameworks and BCP strategies proved effective, FMIs will need to continue to bolster efforts in these five areas to be prepared for the next market disruption or crisis.