Managing capital and liquidity impacts on collateral management

Transcription

1 Managing capital and liquidity impacts on collateral management Ben Watson

2 About your presenter Ben Watson has worked for more than 20 years as a quantitative analyst in investment banking. Until 2012 he was the APAC regional head of Quantitative Analytics for RBS. Prior to this, Ben was the local head of Quantitative Analysis at ABN AMRO Australia. Today Ben is the CEO of Maroon Analytics Australia, a consultancy specialising in quantitative analytics. With a long track record of working with traders to build real time pricing and risk management systems, Ben has developed credit, bond, swaps, forward FX, swaptions, inflation bonds and swaps, MBS and CDS systems. Most recently he managed the successful OIS migration of a large derivatives trading book for a global investment bank. ben.watson@maroonanalytics.com

3 Agenda How are banks capital and funding needs changing under latest compliance and market environment? Strategies to maximize capital efficiency, reduce balance sheet complexity, and promote liquidity mobility Intraday monitoring of liquidity ratios and establishing contingency funding plans Understanding the correlation to Basel III and collateral management Strategies to enhance operational efficiency and reduce risk through portfolio compression

4 The Making of a Crisis The World of 2006 Liquidity Risks Rapid expansion of cheap credit Ninja loans, CDO s Off-Balance Sheet Financing (OBSF) Asset bubbles U.S. and UK Housing (and others) Commodity, Equity and Rates all heading in the same direction Asset/Liability Mismatch RBS, Northern Rock, Bear Sterns, plus others Excessive Leverage Lehmans, Bear Sterns, CDO^2 Ignorance of Risk CDO s, CDS s, Libor = Risk Free, Excessive Risk Concentration AIG, CDO s

5 The Making of a Crisis The GFC (in words) Crisis of Credit Sub-prime defaults Asset write-downs Crisis of Liquidity OBSF really on Balance Sheet Increased funding requirements Collateral calls Funding squeeze Forced sellers Further asset write downs Interbank seizing up Interbank Disruptions Contagion Clustering of Defaults in September 2008 Crisis of Capital Bailouts - AIG, Fannie Mae, Freddy Mac, BOA, Citi, RBS, Lloyds, Northern Rock, + others

6 GFC (in pictures) Interbank credit and the changing idea of what is risk-free.

7 GFC (in pictures) Liquidity Squeeze. Banks were short USD paid up via the XCCY basis market.

8 GFC (in pictures) Tenor Basis Preference for shorter tenor reflecting the desire to receive more regular interest payments.

9 GFC (in pictures) Market Disruption Markets losing BID/OFFER. Gapping Markets- even FX

10 Post GFC Interbank Credit OIS/CSA Discounting Redefining of what is considered risk-free Interbank facing will now only face each other On a CCP s (LCH Swaps, ICE CDS s, + others) Or where there is a CSA in place CCP s Initial margin, contributions to default funds Variation margin paid daily Collateral posted in the same currency as the trade. Protection of MtM and Risk Vanilla single CCY trades only (slightly structured trades allowed) CSA s No Initial margin (yet) Variation margin only above a threshold Paid as per the CSA could be daily, but not necessary the case Collateral does not have to in the same currency as the trade Protection of MtM above the threshold. Loss of risk position

11 Post GFC Basel III 4.5% of common equity - up from 2% in Basel II additional capital buffers mandatory capital conservation buffer of 2.5% discretionary counter-cyclical buffer possible another 2.5% Leverage ratio - tier 1 capital/ average consolidated assets 3% under Basel III Fed requirements 6% for systemically important financial institution 5% for the insured bank holding companies Liquidity requirements Liquidity Coverage Ratio (LCR) high-quality liquid assets to cover net cash outflows over 30d Net Stable Funding Ratio (NSFR) stable funding > the required funding over a 1y of stress U.S. Significantly tighter LCR requirements

12 Basel III / Dodd-Frank / EMIR Basel III - Increased capital charges Capital charge to include CVA for unsecured counterparties Banking books RW s for re-securitisation exposures increased by 200% to 300% Collateral and mark-to-market exposures to CCPs to have risk weight of 2% Dodd-Frank Mandatory clearing of swaps Mandates the posting of independent amounts for uncleared. Similar to initial margin Volcker Rule EMIR CCP re-registration looking at CCP capital requirements

13 Increase use of Clearing Clearing is growing globally. For swaps LCH is the primary beneficiary. Increasing concentration risk CCP waterfall model => mutualisation of losses to banks Open question. Who is going to bail out LCH if they fail and capital calls cause banks to fail? Bank of England? RBA? U.S. Fed?

14 Credit Implications CCP s decrease bilateral credit risk Face the CCP rather that the counterparty Inter-Counterparty netting. Inter-Product netting limited to products covered by the CCP Credit intensive products such as XCCY swaps not covered Time zone mismatch means some residual credit However Increased Concentration Risk CSA s also decreases bilateral credit risk Still face the counterparty but reduce the exposure Residual Risk due to bespoke nature of the CSA Inter-Product netting, but not Inter-Counterparty OIS Discounting Risk-free is now present in pricing reflecting the underlying credit CSA Discounting Less clear cut banks ignoring some residual credit CVA charge for unsecured counterparties Australia/Europe/US yes. Asia no (not yet) CVA hedging in theory(!!!) will mitigate credit risk

15 Liquidity Implications CCP s / Mandatory Clearing Ini al Margin. liquidity requirements Daily Variation Margin. liquidity requirements CSA s increase liquidity requirements due to Varia on Margin. liquidity requirements Multi-Currency CSA and non-local currency CSA s. non-local ccy liquidity requirements Independent Amounts (i.e. initial margin). non-local ccy liquidity requirements (not implemented yet) FRA/OIS cross gamma effect (OIS/CSA discounting) FRA/OIS basis widening will increase exposure => more collateral required. liquidity requirements. LCR Liquidity buffers. liquidity and capital requirements

16 Other Implications Deterioration in unsecured counterparty credit Increases the capital that is set aside. liquidity and capital requirements Haircuts when collateral CCY trade CCY. liquidity requirements 8% haircut would apply to initial and variation margin Rewrite of the SCSA s Rehypothecation Rules Final WGMR rules allows rehypothecation on uncleared derivatives only under strict conditions. liquidity requirements (a lot) Collateral Concentration limits 50% limit on a single form of collateral. funding costs, liquidity May decrease cross boarder trading (EU v s Japan) Mandatory clearing concentration risk. liquidity requirements Volcker Rule Complex correlation rules. CVA hedging may break the Volcker Rule Complex cross ownership structures. liquidity requirements

17 Basel III Capital and Risk Transfer Basel III increases capital charges materially and make certain banking activities much more capital intensive New market and regulatory environment Capital Credit Risk (par cularly Counterparty Credit) at the expense of Concentration Risk Liquidity Risk Risk can not ever be eliminated It can only be transformed

18 Maximise Capital Efficiency and Balance Sheet Complexity, Liquidity Mobility Use CCP s Popular and mandated (U.S. now, EU 2015/16, AU will follow). Outsource regulatory risk and some middle office functionality. Trading the risk held a CCP is the simplest Initial margin to be paid (covers close out risk) ~ 10 day VaR. Is complex. Particularly for cross margining makes it difficult to manage liquidity risk. Sub-optimal funding CCP transparency is not great in the following areas; Initial Margin, Cross margining and Revaluation Not great for liquidity mobility CCP s have very conservative collateral eligibility criteria Less efficient treatment of collateral Having multiple CCPs is useful from the aspect of minimising concentration risk However you do give up some counterparty netting

19 Maximise Capital Efficiency and Balance Sheet Complexity, Liquidity Mobility Use multi-currency CSA s Helps capital efficiency - funding in the cheapest to deliver CCY. Option to switch collateral promotes liquidity mobility However multi-currency CSA risk has optionality Difficult hedge in a trading book, particularly when the forward rates imply a collateral switch. Collateral switching can be hedged but is complex Curve Cutover Points GBP, USD and EUR OIS Curves ATM Option To Switch Collateral GBP USD EUR Tri-Currency CSA Curve

20 Maximise Capital Efficiency and Balance Sheet Complexity, Liquidity Mobility Use Non-Local Currency CSA s Provides an alternative form of funding, but still could be suboptimal. Not as complex as multi-currency CSA s to manage does introduce spot FX risk into the swaps book. Attractive option if you have a natural source of funding in a particular currency. 8% haircut on initial and variation margin will make these CSA more expensive. Promotes liquidity mobility Use Local Currency CSA s or SCSA s Funding is restricted to the currency of the trade Almost always sub-optimal No initial margin (for now) Traded risk is the same as a CCP Does not promotes liquidity mobility At risk of a funding squeeze. SCSA s not popular. Issues over the settlement process

21 Capital Efficiency - Collateral Optimisation Collateral Optimisation Cheapest-to-deliver assets against liabilities Multi-Currency CSA s? Maximise the difference b/w repo and the cash rate Repo haircuts v s OTC Haircuts Repo are agreed at trade time v s OTC haircuts are within the CSA CSA Discounting -> Valuations vary by collateral Novate to CSA valuations that a smaller MtM i.e. try to receive the higher MtM and pay away the lower MtM. For cases where we are the collateral receiver (i.e. positive MtM) we are able up fronting the funding differences b/w the collateral choices. For cases where we are the collateral poster (i.e. negative MtM) we are able to shrink the collateral commitments. Avoid assets that are subject to haircuts Cash is best.

22 Liquidity Management LCR Highly-liquid assets equal to or greater than the net cash over 30d At least 100% coverage Intraday Expected daily gross liquidity inflows and outflows (max intraday liquidity) Monitor intraday liquidity positions (start of day + inflow-outflows) Forecasting the net funding shortfalls (stress testing) Manage and mobilise collateral as necessary (stress testing) Manage the timing of its liquidity outflows Prepared to deal with unexpected disruptions to its intraday liquidity flows (Contingency Funding Plans CFP)

23 Liquidity Stress Tests Liquidity Supply Side Stress Indicators; Rating downgrades (stress of liquidity providers) Credit watches, Credit spreads, Widening on sub debt, CDS spreads Deterioration of asset quality (real economy stress) Increase in defaults and recovery levels, Loan provisions, Widening of loan margins, Syndicated loan margins Wholesale market disruption (access wholesale funds or replace maturing liabilities) FRA/OIS widening, Repo increase in haircuts, collateral restrictions, ASW on bonds, XCCY Basis widening, New Issue Coverage, MM Spreads Deposit run-off (bank runs, real economy stress) Declines in deposits, Early redemption of CD s Secondary market disruption (ability to liquidate assets) Widening of spreads, Increase in Bid/Offer, Stock holding periods Liquidity Demand Side Stress Indicators; Collateral Calls (increased volatility of market) Decline in MtM of OTC derivatives Initial Margins Increased initial margin in times of stress

24 Contingency Funding Plans (CFP) APRA APS 210 (liquidity) requires a CFP. What should be in a CFP Definition of what stress would look like => Stress tests Pre-alarm: intense monitoring of a set of early warning indicators following an observed idiosyncratic or systemic shock Alarm: escalation levels that are associated with actions Alarms could be; breaches of the LCR or other liquidity ratios, shortfalls on central bank reserve accounts, measures on funding conditions Responsibilities / Fire drills Who and what should people be doing in a crisis Sources of Contingency Funding CB facilities, Interbank MM, Bond issuance, Intergroup liquidity facilities, Asset sales, Securitisation, Off-balance sheet cash boxes, Repo, Liquidity facilities (uncommitted credit lines)

25 Basel III: Impact on Collateral Management Basel III and collateral Collateral treatment is broadly the same as Basel II Risk exposure calculations Issue: Close out times during times of stress => Illiquidity Margin period of risk of 5 to 10 days to change to 20 days (or more if there is a risk concentration with a single counterparty) Could double to 40 days if there are margin disputes Rehypothecation Issue: liquidity management process more difficult Nature of collateral re-use is consistent with liquidity needs Does not jeopardise the ability to post or turn collateral in a timely manner Downgrade triggers in CSA s Issue: downgrade => more collateral => deterioration of credit CVA - windfall of collateral not allowed in the EAD calculations Non-cash collateral Issue: Correlation of Non-Cash collateral and the MtM haircuts if banks are not able to model the correlation

26 Operational Efficiency and Portfolio Compression Central Collateral Desks Making the best use of inventory across the entire firm to satisfy all collateral requirements Able to internally net trades across asset classes Ability to perform internal portfolio compression Required by EMIR/ CFTC Collateral effects pricing so some of the function should be linked to the front office. Cash rate v s Repo Repo Haircuts v s OTC Haircuts Should the money market and repo desks be merged as well?

27 Conclusions Capital and costs are higher when trading OTC derivatives. Means collateral optimisation is essential if you want to be profitable and competitive. Credit risk mitigated at the expense of Concentration Risk Impact of CCP failure such LCH would catastrophic Liquidity Risk Difficult to measure. Management requires more capital.