Bank risk manager of the year: Deutsche Bank

Risk Awards 2022: Seasoned risk team put on a masterclass in how to manage margin risks

Stuart Lewis, Deutsche Bank

Photo: Deutsche Bank

The blow-up of Archegos Capital Management last year could hardly have come at a worse time for Deutsche Bank. Of the family office’s numerous prime brokers, Deutsche was already looking to get out of the game, having struck a deal in 2019 to transfer its franchise to BNP Paribas by 2022.

Crucially, risk management of existing client positions remained with Deutsche throughout the intervening period – meaning a risk team with decades of combined experience and deep knowledge of its clients was at the helm as the fund burned brightly in 2020, and then imploded spectacularly in the first quarter of 2021.

The bare facts of the episode are well trodden: Archegos had made big bets on a very small number of mostly tech and media stocks, and was highly levered across multiple primes. A series of uncorrelated market moves resulted in sharp declines in the value of those stocks, which ultimately led to the collapse of the fund on March 24. Archegos itself is reportedly under investigation by the US Securities and Exchange Commission for market manipulation.

But an event that led to eye-watering losses at rivals ended with Deutsche “handing back collateral” to the client after exiting its positions, as Christian Sewing, the bank’s chief executive, and chief risk officer Stuart Lewis noted during a first-quarter earnings call last year.

Lewis – now in his final year before retiring after more than a quarter of a century with the bank, having joined from Credit Suisse in 1996 – declines to comment specifically on Deutsche’s position management of Archegos – but notes with a wry smile that he’s seen this movie before.

“In the 25 years I’ve been very closely involved in the hedge fund business, you sometimes have to look for the little things. I think you have to have a really strong dialogue with the first line to say: ‘Look, are you noticing these little things? Which maybe on their own wouldn’t mean too much – but on a cumulative impact, it’s making us unsettled’,” says Lewis, adding simply: “That’s how we’ve always run it.”

As Archegos’s positions deteriorated in March, those small things quickly got large for Deutsche’s rivals – assuming they noticed them at all. Where some were stuck using static margin models that failed to reset collateral demands when values changed materially, Deutsche runs a daily stress-loss shortfall that seeks to determine whether, if it had to liquidate its position, it would still hold excess collateral, or be left nursing a hefty loss.

Watching the defectives

“We maintain watchlists to capture early warning events and enforce heightened oversight. Triggers, some of which were applicable to Archegos, include exponential fund growth, large net asset value drops, and/or fund withdrawals. Experience has taught us that proactively, for example, identifying potential risk events early – quarters or even a year ahead – of a fund crisis can insulate you from a loss event,” says Peter Yearley, chief risk officer for the bank’s corporate and investment bank.

If Archegos was added to Deutsche’s internal watchlist – the bank declines say whether it was – then risk managers would have been watching the fund’s every move closely even when it was delivering stellar returns. Ironically, it was those returns that led to a client with a diversified portfolio becoming dramatically concentrated – as well as implying significant funding growth for its prime brokers and a rise in material risk exposure, something which should have raised red flags.

For funds that make its watchlist, Deutsche’s prime brokerage teams begin stress-testing positions more strenuously – to the point of looking at the composition of what’s driving moves in certain illiquid stocks, for instance, to gauge jump to default risk. “By that metric you might see, for instance, in stress tests a stock that otherwise looks healthy go to zero. That would attract attention and raise red flags,” notes Lewis.

For such clients, the bank uses dynamic hedging to mitigate concentration risk by increasing the margin on some positions to very high percentages and raising the aggregate requirements. It is understood Deutsche held aggregate margin of roughly a quarter on Archegos’s portfolio, but on some positions it was more than a third – or more than treble what some peers held.

“We want clients to have a diversified portfolio. If a book becomes concentrated, we need to see remediating action – either adding names, or taking down the concentration. And, equally, adding margin to those sorts of positions to get us back to a point, looked at from a stress-loss perspective, of being adequately within our risk appetite,” says Lewis. “And I think we’ve got a cadence now within the hedge fund group where there’s a kind of systematic way of looking at when we should add a firm to a watchlist.”

He adds: “The other solution you always have is to increase margin. And eventually when you margin at 100%, then trades are going to go away from you.”

Margining positions at 20–25% margin would imply leverage of around four or five times; some rival primes were in effect offering multiples of this, by deliberately competing on margin.

“I think a real key differentiator is our pricing of risk during periods when we get concerned. We have a very different approach, which effectively means that positions are put elsewhere,” says Lewis. “The leadership of prime broking and hedge fund teams have tremendous pride in the way they risk-manage the business jointly. They’ve got great expertise. It’s that, I think, that has been the driver here. Their experience and expertise around the control process, and close alignment between risk and the hedge fund business, has driven this outcome.”

Not so fast

For the most part, 2021 wasn’t a testing one for market risk managers: many had instead expected a bloodbath in credit, with zombie businesses being kept alive by Covid loan moratoria and various forms of government support going to the wall as those measures were gradually unwound.

But where many banks’ expected credit-loss (ECL) models were telling them to blindly release billions in reserves as macro indicators rebounded, Deutsche’s credit teams once again chose to maintain a management overlay – this time holding additional reserves for stage one and stage two loans in the transport, hospitality and care sectors in particular.

In its full year results, the bank said it retained loan loss provisions of €500 million – a drop from €1.8 billion the year before, but a far narrower gap than almost all its peers.

“Looking at some of the consumer sectors that we serve, it wasn’t necessarily clear to us the economic impact of Covid was behind us,” says Lewis. “I think that’s just a question of being prudent. Models are great, but I think having that sort of qualitative overlay is something that we as a risk management group generally see as a positive thing. If you just slavishly follow the models, then sometimes the outcomes can be too positive, or maybe a bit a bit too negative.”

The bank hasn’t had things all its own way – it saw its knuckles rapped in April by its host regulator Bafin over continued concerns over its anti-money laundering controls. The news followed the announcement that Joe Salama – its general counsel in the US who has led negotiations with US authorities over several regulatory settlements – was to become the global head of anti-financial crime, with oversight once again split from the CRO’s team.

Lewis says the move was in part driven by succession planning, ahead of CRO-elect Olivier Vigneron’s proposed appointment this year.

As was the case last year, the team acknowledges it is still closing the chapter on misdemeanours of the past. Unlike incidents it faced in the past, conduct issues that reared their heads last year were dealt with swiftly: though the bank is contesting claims it mis-sold hundred of millions of euros’ worth of derivatives to a Spanish property developer – it recently called them “without foundation” in a court hearing – an internal investigation understood to have been linked to the episode led to the hasty departures of Louise Kitchen, head of Deutsche’s asset wind-down unit, and Jonathan Tinker, co-head of its mighty forex business.