PRA writes to chief risk officers regarding use of SIMM model

PRA writes to chief risk officers regarding use of SIMM model

Reporter Bob Currie

29 June 2022, UK

The Prudential Regulation Authority (PRA) has sent a letter to chief risk officers warning that firms which use margining methodology which include the SIMM model for Uncleared Margin Rules (UMR) may run the risk that margin levels are inadequate to cover their risk.

The “Dear Chief Risk Officer” letter is sent in the name of three PRA senior executives, executive director supervisory risk specialists Duncan Mackinnon, executive director UK deposit takers David Bailey, and executive director, authorisations, regulatory technology and international supervision Nathanaël Benjamin.

In the letter, the authors highlight that the market distress created by the COVID-19 pandemic, the Archegos default, and disruption to commodities markets caused by the Russia-Ukraine conflict has triggered a series of regulatory initiatives designed to evaluate the performance of margining frameworks for both cleared and non-cleared derivatives.

Against this background, the PRA recently conducted a review of the use of the Standardised Initial Margin Methodology (SIMM) by large banks to assess the performance of SIMM under COVID conditions and to evaluate levels of compliance with regulations governing exchange of margin for non-centrally cleared derivatives contracts.

In its conclusions, the PRA finds that the existing margin governance process, in which firms rely primarily on the International Swaps and Derivatives Association (ISDA) governance for SIMM updates and for negotiating add ons for model underperformance, may result in under-margining for some counterparties — a position where margin levels are inadequate to cover risks at a 99 per cent confidence level as required by the regulations.

Under UMR Phase 6, a large number of smaller counterparties will fall under the scope of the UMR regulation from September 2022. The signatories to the PRA letter anticipate that a significant number of these Phase 6 firms — a share of which may be hedge funds — have risk profiles that differ significantly from those to which SIMM has been applied to date (particularly large broker-dealer and bank portfolios).

“Hence it is even more critical that SIMM model governance can enable firms to promptly identify and remediate model underperformance,” says the letter.

The PRA’s concerns relate particularly to use under SIMM model governance of one predominant performance metric, so-called ‘3+1 backtesting’. The Authority is concerned that 3+1 backtesting may not always identify poorly-performing models, as required by the Regulatory Technical Standards (RTS).

By this fact, it indicates that the resulting initial margin (IM) exchanged on the basis of this modelling may not be sufficient to cover risks at the 99 per cent confidence level, as required by the RTS for certain counterparties.

In cases where firms rely on the global ISDA governance process for updating SIMM or negotiating add ons, the PRA fears that this may be inadequate to ensure that timely action is taken to address model underperformance.

The PRA says that its findings do not relate primarily to the model design, such as the calibration methodology. Rather, its primary concern is to ensure that all in-scope firms under UMR are adequately margined on an individual portfolio basis and are fulfilling the requirement of the RTS.

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

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

Both the risk assessment and the remedial action must be completed by December 2022, with firms required to report these actions to their financial supervisors.

Responding to the PRA letter, an ISDA spokesperson made the following comment to SFT:
“The ISDA SIMM performed robustly during the COVID crisis and the extreme volatility caused by Russia’s invasion of Ukraine, with no widespread and material instances of under-margining reported by its wide universe of users."

"We continually review the SIMM methodology and governance, and the methods we use to assess the performance of the ISDA SIMM meet requirements across regulatory jurisdictions. We look forward to further engaging with the UK PRA to address its concerns,” says the ISDA spokesperson.

Top