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Financial Services Law Insights and Observations

Fed reiterates supervisory guidance on risk management

Federal Issues Federal Reserve Bank Regulatory Bank Supervision Risk Management Derivatives

Federal Issues

On December 10, the Federal Reserve Board announced SR Letter 21-19, which reiterates the Fed’s supervisory expectations for large banks’ risk management practices related to investment funds. The letter applies to institutions supervised by the Fed that have large derivatives portfolios and relationships with investment funds, and follows a review by the Fed of the high-profile default and failure of one investment firm, which resulted in losses of more than $10 billion for several large banks. Among other things, the Fed warned firms that poor communication frameworks and inadequate risk management functions hinder their potential to identify and address risk, and that “[r]isk management and control functions should have the experience and stature to effectively control risks associated with investment funds.”

The Fed also reminded firms that, consistent with the guidance in Interagency Supervisory Guidance on Counterparty Credit Risk Management, they should: (i) “[r]eceive adequate information with appropriate frequency to understand the risks of the investment fund, including position and counterparty concentrations, and either reconsider the relationship or set sufficiently conservative terms for the relationship if the client does not meet appropriate levels of transparency; (ii) “[e]nsure the risk-management and governance approach applied to the investment fund is capable of identifying the fund's risk initially and monitoring it throughout the relationship, and 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”; and (iii) “[e]nsure that margin practices remain appropriate to the fund's risk profile as it evolves, avoiding inflexible and risk-insensitive margin terms or extended close-out periods with their investment fund clients.”