Federal Reserve reminds banks on requirements for risk supervision of investment funds

The Federal Reserve is concerned with practices where, both at the inception of a fund relationship and, on an ongoing basis during periodic credit reviews, firms accept incomplete and unverified information from the fund, particularly with regard to the fund’s strategy, concentrations, and relationships with other market participants. These concerns are heightened where a fund client has a history of concentrated positions and losses. More generally, these practices represent insufficient due diligence and may be inconsistent with safe and sound banking practices. Similarly, when initiating a relationship and on an ongoing basis, firms should obtain critical information regarding size, leverage, largest or most concentrated positions, and number of prime brokers with sufficient detail or frequency to determine the fund’s ability to service its debt. 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 or whether they can use strong compensating measures, such as significantly more stringent contractual terms, to mitigate the risk.

Consistent with the guidance in Interagency Supervisory Guidance on Counterparty Credit Risk Management, firms should:

  • Receive 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;
  • Ensure 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
  • Ensure 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.

The full letter is available at https://www.federalreserve.gov/supervisionreg/srletters/SR2119.htm

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