Lending money to an investment firm based on a standing relationship is a natural part of doing business. Risking your balance sheet in the process, however, is not. Your models need to be tested and the numbers need to match up lest you wander through the weekend wondering, in the back of your mind, if you made the right call.
More than a half dozen banks lent billions of dollars to family office Archegos Capital. When the firm began to lose money, the banks issued margin calls to Archegos to increase capital buffers against losses. When the margin calls were not met, some of the banks began selling off the collateral (which were shares of the stock held by Archegos) reportedly creating a downward price spiral in their stock holdings and cementing massive losses.
The implosion of Archegos is a prime example of how running a precautionary stress test or “What-If” scenario using risk analytics tools could offer some buffer to large losses.
While it was impossible to tell exactly how much Archegos levered up its bets, mitigating any loss in invested capital never hurts. Testing a trade, collateral holdings or even a loan amount against potential losses is an optimal way to approach risk management. But not everyone has the tools to do this quickly and thoroughly.
Family offices do not have to report quarterly holdings which makes managing risk difficult to gauge. Furthermore, Archegos used swaps that also did not necessarily need to be disclosed to lever up investments. The fund’s meltdown, into the billions of dollars, has prompted regulators to look at whether they need to shore up the margin rules for derivatives trades, among other regulatory protocols.
Shouldn’t a bank’s internal risk controls already do that before regulators get involved?
In an ideal world to mitigate risk, you need to:
- Run stress scenarios – early and often
Concentrated risk needs to be monitored and predictive analytics applies here. An analytical tool that lets you instantaneously calculate hypothetical liquidity shocks and quickly and clearly show the results could remedy some of the losses.
- Play with “What-If” scenarios
Test out scenarios on “what would happen if…” What happens if the losses triple within a short period of time? A quick check of forward-looking scenarios would give managers and regulators a sense that you have your risk under control. Analytics tools that can branch off a segment of trade, loan or other instrument can help you figure out what *might* happen if something goes awry. These scenarios can be documented once again showing you’re responsible for managing your risk.
- Make “predictive analytics” a best practice
You don’t necessarily need a crystal ball to manage risk but you do need the right tools, and then the ability to take it forward. Regulators are looking for clean risk management protocols and results that do not leave room for interpretation. Easier said than done but internal risk management and regulatory risk management should go hand-in-hand.
While the primary reasons for the Archegos event will continue to be reviewed by regulators and risk and compliance staff, this does not underscore the need for Primer Brokers to have systems in place that make it easier for them to understand the drill down into their exposure with each customer from different angles.