FSA starts monitoring banks’ management of collateral

The Financial Services Authority (FSA) has started investigating how large investment banks manage their collateral, fearing they may not be ready for a sudden market downturn.

The regulator will be asking the banks about the quality of their systems for assessing collateral by checking they have sound collateral agreements, that collateral is correctly valued and appropriate haircuts are imposed, and that the correlation between collateral and the value of the underlying exposure to the counterparty, in normal and in stressed environments, is reviewed. It will also look at whether collateral can be realised quickly – and recovered quickly – if the underlying obligation to the counterparty is extinguished.

This increased surveillance comes at a time when collateral is growing increasingly important in banks’ management of counterparty credit risk, especially with hedge funds. Regulators are also worried about banks’ prime brokerage arms relaxing their criteria for lending to hedge fund clients, in an increasingly competitive environment. These fears are exacerbated as a default in the private equity sector seems inevitable, due to levels of leverage and the recent decline in the economic cycle.

The FSA is expected to report back on the results of this study to the industry during the first half of 2007, perhaps in the form of a statement of good practices. In a discussion paper on private equity published last month, the FSA announced that it would look at firms’ default plans “as a matter of priority”, and that this would be a “key area of focus over the next 18 months”. Collateral management was also highlighted in the FSA Business Plan for 2006/7.