Are current CCR frameworks still fit-for-purpose given the increasing size of NBFIs?

Counterparty credit risk (CCR) frameworks face increasing challenges due to the rapid growth and complexity of Non-Bank Financial Institutions (NBFIs), which present systemic risks that current models may inadequately capture.  

Despite reforms, vulnerabilities remain in transparency, risk modelling, and regulatory coordination, necessitating enhanced oversight and improved risk management approaches.

1. Opacity and data limitations: Many NBFIs lack transparency in their risk profiles and leverage, impeding effective CCR management and increasing systemic shock risks due to crowded trades and concentrated leverage.
   

2. Systemic risk amplification via liquidity strains: Collateral practices reduce direct credit risk but can exacerbate systemic stress during market downturns as margin calls force leveraged NBFIs into rapid asset sales, creating negative feedback loops in asset prices.

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3. Model and risk management gaps: Existing CCR models often underestimate wrong-way risk and struggle with complex stress scenarios and excess collateral effects, while fragmented risk management across institutions leads to blind spots during crises. 
   

4. Regulatory reforms and persistent vulnerabilities: Global regulators propose enhanced due diligence, expanded stress testing, and stronger collateral management, yet challenges remain in systemic risk transmission, liquidity pressures, incomplete regulatory coverage, and supervisory coordination. Recommendations include mandating transparency, integrated stress testing, harmonized oversight, holistic risk management, and dynamic modelling. 

Proposed reforms by global regulators will strengthen CCR frameworks

Over the past several years Global Regulators and Banks have taken important steps to strengthen CCR management and more recently there have been multiple calls by the European and UK regulators to strengthen CCR frameworks in the face of growing NBFI prominence:

1. Enhanced Due Diligence and Disclosure Expectations: Emerging guidelines encourage deeper investigations into NBFI counterparties, though real-world data granularity and timeliness remain problematic.
   

2. Expanded Stress Testing: Supervisory programs increasingly include scenarios simulating NBFI defaults and leverage unwinds, revealing potential contagion channels and concentration risks across key banks.
   

3. Collateral and Margining Practices: Stronger collateral management and margin requirements help mitigate idiosyncratic losses but may increase systemic liquidity pressures during market downturns.

Despite improvements, significant vulnerabilities remain including:

1. Systemic Risk Transmission via NBFI Linkages: Concentrated exposures to a handful of large NBFIs create contagion risk that can cascade through the banking sector, potentially amplifying losses far beyond direct exposure.
   

2. Liquidity Strains from Margin Calls: Sudden spikes in collateral demands may force fire sales in stressed markets, which can deepen financial instability.
   

3. Incomplete Regulatory Coverage: Existing frameworks often fail to capture the dynamic, rapid risk accumulation common in NBFIs, due to limited data and jurisdictional fragmentation.
   

4. Coordination Challenges: Differing supervisory approaches and fragmented data sharing hinder comprehensive risk assessment and response across banks and the broader financial system.

Recommendations for Fit-for-Purpose management of NBFI exposures

1. Mandate Greater Transparency: Regulators should require standardized, timely disclosures by NBFIs and their bank counterparties to improve visibility into leverage, risk concentrations, and exposures.

2. Enhance Integrated Stress Testing: Stress scenarios should better incorporate multi-step contagion effects from NBFI distress, including liquidity and collateral dynamics.
   

3. Improve Supervisory Coordination: Harmonize regulatory standards and strengthen cooperation between banking and NBFI regulators domestically and internationally.
   

4. Adopt Holistic Risk Management: Establish standard methodologies across risk functions to identify emerging vulnerabilities quickly and comprehensively.
   

5. Develop Dynamic Risk Models: Create and deploy real-time, forward-looking models capturing wrong-way risk and evolving market correlations in NBFI exposures.

The rise of NBFIs as significant financial intermediaries profoundly tests the robustness of traditional CCR frameworks. While regulatory and industry reforms have enhanced resilience, achieving a truly fit-for-purpose CCR regime requires deeper transparency, more comprehensive risk tools, and agile regulatory coordination.  

Without these advances, banks and the broader financial system remain exposed to shocks triggered by NBFI defaults and dislocations akin to recent stress events.

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