The fallout from Credit Suisse’s collision with Archegos reveals valuable lessons for other banks, Andreas Ita writes in an essay for finews.first.

This article is published on finews.first, a forum for authors specialized in economic and financial topics.

Credit Suisse’s 4.4 billion Swiss francs ($4.7 billion) hit from the collapse of hedge fund Archegos illustrates the limits of capturing all potential risks of a highly complex and leveraged business, even with sophisticated risk models.

It also underscores how essential it is that senior managers, board members, banking regulators, and auditors understand the mechanics, risks, and dependencies of a bank’s business model. Only by doing so they can pose the right questions and raise challenges.

What are the lessons learned for other banks dealing with huge and highly leveraged stock positions provided to clients through derivatives?

Not Aware

First, it appears that Credit Suisse’s senior management and board of directors might not have been aware of the enormous exposure of their bank with a single client. In fact, the exposure might have been difficult to detect given the specific deal structure which involved total return swaps.

In a total return swap, the exposure versus the client is neither visible from the bank’s balance sheet nor the Value-at-Risk (VAR).

Given the collateralization, the instruments’ counterparty credit risk was likely heavily underestimated. This because the share price moves were much larger than predicted by commonly-used models. The challenge is to find new methods to identify and limit hidden exposures of these types.

Several Banks

Secondly, if clients hold similar exposures with several banks – none of whom are aware of each other – a cascade of hedge position liquidations can amplify share price tumbles, well beyond the worst-case predictions of statistical models used to determine margin requirements.

The key challenge here is requiring clients to report their entire exposures per underlying positions or to restrict them in doing similar trades with other banks in the same underlying. In addition, banks should include the price impact from hedge position liquidations into their sophisticated counterparty credit risk models.

Orderly Liquidation

The third lesson pertains to the market liquidity of the stocks involved. The massive trading volumes observed during the critical days suggest that the bank’s hedge positions were a multiple of the normal daily trading volumes. This also amplified the price impact of the forced position liquidations.

For banks, the challenge here is to set limits on total return swaps and other derivatives exposures per underlying and counterparty. This would allow an orderly liquidation of hedge positions in case the counterparty defaults.

Renewed Warning

Banks should also include the expected price impact of forced hedge position liquidations into their models, based on the size of positions relative to daily trading volumes. Archegos is a renewed warning for banks not to be lulled into a false sense of safety by sophisticated risk models introduced following the 2008/09 crisis.

Andreas Ita is the founder and a managing partner of Orbit36, which advises banks and insurers on strategic planning as well as risk and capital management. The Swiss banker began his career trading equity derivatives and worked for a total of 22 years at UBS. Most recently, he was the Swiss bank’s head of group economic performance and capital optimization until mid-2019. He holds a Ph.D. in banking and finance from the University of Zurich.

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