Better Markets filed a comment letter with the Basel Committee on Banking Supervision on its proposed guidelines for the management of counterparty credit risk (CCR).

Why It Matters. The opaque and interconnected web of megabanks’ counterparty credit risk (CCR) exposures can amplify the effects of market shocks, send financial systems into crisis, cause government bailouts, and impose great costs on consumers, investors, and small businesses. These CCR exposures are ticking time bombs that regulators have largely ignored—other than rhetorically—for far too long. Meaningful, concrete, and specific action is long past due.

What We Said. Counterparty credit risk refers to the risk of nonpayment of amounts owed. If I lend $10 to a friend, that friend is my counterparty and my CCR exposure is $10. A megabank may have CCR from financing the trading activities of hedge funds, from its extensive network of derivatives contracts with other megabanks, nonbank financial firms, and others, or from borrowing and lending securities for a variety of purposes. These activities create risks that are complex and consequential.

A more prudent regulatory approach to CCR measurement and tighter exposure limits would have the force and effect that existing supervisory guidance has long been unable to achieve. Accordingly, Better Markets recommends that the Committee:

• repair weaknesses in its CCR measurement framework—weaknesses that the Committee itself has identified in its proposed guidelines;
• tighten its single counterparty net exposure limits, in recognition of the speed with which social media can amplify counterparties’ concerns about a bank; and
• introduce single counterparty gross exposure limits into its large exposure framework.

Bottom Line.The Committee also should revise the proposed guidelines to move beyond the toothless encouragement of ’sound practices’ that characterize previous CCR guidance. The revised guidelines should clearly identify CCR management deficiencies that are unacceptable. These include operating a bank without the ability to timely aggregate CCR to a single counterparty and operating without limits on single counterparty gross exposures to protect the solvency and liquidity of the bank. The guidelines should unambiguously state that national supervisors should use the authorities available to them to take timely action—including while risks are building, and not merely after a blow-up has occurred—to require banks to correct deficiencies in CCR management, including ensuring that banks measure and limit their CCR exposures within safe and sound limits.