Securities Finance Industry News | PRA writes to Chief Risk Officers regarding use of SIMM model

The Prudential Regulatory Authority (PRA) has sent a letter to chief risk officers warning that firms that use a margin methodology that includes the SIMM model for uncompensated margin rules (UMR) may run the risk that levels margin are insufficient to cover their risk.

The “Dear Chief Risk Officer” letter is sent on behalf of three senior PRA executives, Executive Director Supervisory Risk Specialist Duncan Mackinnon, Executive Director UK Deposit Takers David Bailey and Executive Director, Licensing, Regulatory Technology and International Oversight Nathanael Benjamin.

In the letter, the authors point out that the market distress created by the COVID-19 pandemic, the default of Archegos and the disruption of commodity markets caused by the Russian-Ukrainian conflict have triggered a series of regulatory initiatives designed to assess the performance of margin executives. for cleared and uncleared derivatives.

Against this backdrop, the PRA recently conducted a review of the use of Standardized Initial Margin Methodology (SIMM) by major banks to assess SIMM performance under COVID conditions and to assess levels of compliance with regulations governing margin exchange for non-central operations. cleared derivative contracts.

In its findings, the PRA finds that the existing margin governance process, in which firms rely primarily on International Swaps and Derivatives Association (ISDA) governance for SIMM updates and for negotiating additional case of model underperformance, may result in under-margining for some counterparties – a position where margin levels are insufficient to cover risks at the 99% confidence level, as required by regulation.

Under phase 6 of the UMR, a large number of small counterparties will come within the scope of the UMR regulation from September 2022. The signatories of the PRA letter anticipate that a significant number of these phase 6 – part of which may be hedge funds – have significantly different risk profiles from those to which SIMM has been applied so far (notably the portfolios of large brokers and banks).

“It is therefore even more essential that the governance of the SIMM model can enable companies to quickly identify and correct underperformance of the model,” the letter states.

The PRA’s concerns relate in particular to the use, within the framework of the governance of the SIMM model, of a predominant performance measure, called “3+1 backtesting”. The Authority is concerned that 3+1 backtesting does not always identify poorly performing models, as required by regulatory technical standards (RTS).

By this fact, it indicates that the resulting initial margin (IM) traded based on this modeling may not be sufficient to cover risks at the 99% confidence level, as required by the RTS for certain counterparties.

In cases where companies rely on ISDA’s global governance process to update SIMMs or negotiate add-ons, the PRA is concerned that this may not be sufficient to ensure timely action is taken to remedy the underperformance of the model.

The PRA says its findings do not primarily relate to model design, such as calibration methodology. On the contrary, its main concern is to ensure that all companies covered by the UMR benefit from an adequate margin on an individual portfolio basis and meet the requirements of the RTS.

With this in mind, the letter specifies the actions that must be applied by category 1 banks that apply the SIMM models. These firms should carry out a self-assessment of the implementation of mandatory margin requirements for non-centrally cleared OTC derivatives against applicable regulations.

In doing so, they must then provide a corrective action plan to address any deficiencies identified by this self-assessment process.

The risk assessment and corrective actions are to be completed by December 2022, with companies required to report these actions to their financial supervisors.

In response to the PRA letter, an ISDA spokesperson made the following comment to SFT:
“The ISDA SIMM performed strongly during the COVID crisis and the extreme volatility caused by Russia’s invasion of Ukraine, with no widespread cases and sub-margin material reported from its vast universe of users.”

“We continually review SIMM methodology and governance, and the methods we use to assess the performance of ISDA SIMM meet requirements in all regulatory jurisdictions. We look forward to continuing our dialogue with the UK PRA to address their concerns,” the ISDA spokesperson said.

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