Fed reminds large banks of investment risks in Archegos postmortem

The guidance follows a supervisory assessment initiated by the Fed and other U.S. and foreign regulators into what went wrong at Archegos, particularly regarding the lending practices of large banks and whether they properly understood risks posed by bets Archegos made with borrowed funds.

“The Federal Reserve is concerned with practices where, both at the inception of a fund relationship and, on an ongoing basis during periodic credit reviews, firms accept incomplete and unverified information from the fund, particularly with regard to the fund’s strategy, concentrations, and relationships with other market participants,” wrote Michael Gibson, director of the Fed’s Division of Supervision and Regulation.

The Fed encouraged large banks to review existing guidance on counterparty credit risk management to examine current practices and make necessary adjustments if those practices fall short of the regulator’s expectations.

The March 2021 meltdown of Archegos, a family office owned by investor Bill Hwang, led to $5.5 billion in losses for Credit Suisse and a nearly $3 billion hit for Japanese bank Nomura Holdings, as well as smaller losses for several other banks, according to media reports. In the aftermath, Credit Suisse concluded via an independent report that deficient risk culture within the bank contributed to its exposure to the collapse.

Large banks with large derivatives portfolios and relationships with investment funds need to understand not only their concentration of risk in a particular investment firm or strategy but those of other parties as well, the Fed noted. This requires full disclosure of such relationships by the client to the lender; if that level of transparency is not fulfilled, the lender should consider setting more conservative terms.

Banks must not only understand risks posed by client investors at the beginning of the client-lender relationship but as the relationship grows and evolves. They must “ensure applicable areas of the firm—including the business line and the oversight function—are aware of the risk their investment fund clients pose to the firm and have tools to manage that risk,” according to the Fed.

Margin practices must change and evolve with the client-lender relationship, “avoiding inflexible and risk-insensitive margin terms or extended close-out periods with their investment fund clients,” the Fed said.

The report at Credit Suisse concluded its risk management team was aware of the risks posed by Archegos’s investment strategy but chose to ignore or downplay them to realize short-term gains. There was a lackadaisical attitude toward assessing risk and raising red flags; risk assessments of Archegos that Credit Suisse conducted in 2015 and 2018 were largely perfunctory; and there was a “cultural unwillingness to engage in challenging discussions or to escalate matters posing grave economic and reputational risk.’

In response, Credit Suisse has lowered its risk appetite and risk thresholds across multiple divisions, upgraded its risk governance and underlying reporting, and increased margin levels on many types of investments. The bank is also planning to exit prime services, the area of its investment bank most notably linked to its Archegos missteps.

Credit Suisse parted ways with Chief Risk and Compliance Officer Lara Warner and the head of its investment bank, Brian Chin. It fired nine employees and punished 14 others for failing to escalate warnings about the risks Archegos posed to the bank’s finances and reputation. The bank also separated its risk and compliance functions, saying the combination left the division’s leaders with too many responsibilities to manage risk effectively.