Red alert

Banks that deal with large, risky funds must tighten their risk management and margin practices, the U.S. Federal Reserve Board is advising, following a review of the collapse of Archegos Capital Management which inflicted more than US$10 billion in losses on banks.

In a letter to the industry, the Fed set out its expectations for large banks when it comes to their investment fund clients, plus the banks’ counterparty credit risk management and margin practices.

Among other things, the Fed said it’s concerned about banks accepting “incomplete and unverified” information from investment fund clients, “particularly with regard to the fund’s strategy, concentrations, and relationships with other market participants.”

“Regardless of the type of client, banks are expected to undertake proper due diligence with a client and take fully into account the risks that a relationship with a client may pose to the bank,” it said.

Banks also need to ensure that they have insight into funds’ portfolio concentrations, use of leverage and their prime brokerage relationships, the Fed suggested.

“If a client refuses to provide this information, firms should consider whether it is consistent with safe and sound practices for them to begin or maintain a relationship with the fund,” it said.

At the same time, the Fed said that banks should be wary of agreeing to margin terms that are insufficient, given the risk being taken.

“Contractual terms that prevent a firm from improving its margin position or closing out positions quickly if a fund misses margin calls, even when presented with an increasing risk profile at the fund, may be inconsistent with safe and sound practices,” it warned.

Additionally, banks with weak risk management systems, or ineffective governance, will be hampered in their ability to uncover and address risk, the Fed noted.

“Risk management and control functions should have the experience and stature to effectively control risks associated with investment funds,” it added.

The guidance follows a review of the failure of the Archegos Capital hedge fund earlier this year. That firm, which had its portfolio heavily concentrated in a small number of U.S. and Chinese tech and media companies, defaulted on margin calls in March — causing billions of dollars in losses to several large banks.