collateralized banking - ccfz · excessive leveraged financing and massive otc derivatives market...

Collateralized Banking

A Post-Crisis Reality

Dr. Matthias Degen Senior Manager, KPMG AG

ETH Risk Day 2014 Zurich, 12 September 2014

2 © 2014 KPMG AG/SA, a Swiss corporation, is a subsidiary of KPMG Holding AG/SA, which is a subsidiary of KPMG Europe LLP and a member of the KPMG network of independent firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss legal entity. All rights reserved. The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International.

Definition

“Collateralized Banking”

Totality of aspects and processes relating to collateral as well as collateralized business, such as (OTC) derivatives trading, brokerage, Repo agreements or asset lending.*

(*) Source: “Collateralized Banking” - Whitepaper, KPMG Germany (2014)


Overview

1)  When Prime Brokers Fail…

2)  Response from Policymakers

3)  Collateralized Banking – Implications and Challenges

4)  Summary

Disclaimer: The opinions expressed here are purely those of the author, and may not be taken to represent the official views of KPMG.


When Prime Brokers Fail…

… or: Lessons learned from the crisis

  Investment banks (and prime brokers) can and do fail

  Freezing of credit and money markets put spotlight on liquidity risk

  Assessment of risk was misguided and systemic risks were not transparent / understood

  Excessive leveraged financing and massive OTC derivatives market pose a danger to the stability of

global financial markets and the real economy

  Absence of transparency on positions or activities in OTC markets


Response From Policymakers (1/3)

Liquidity risk Capital requirements

  Better quality capital,

  higher capital ratios, capital buffers

  Improved risk capture (mainly counterparty credit risk):

  Capitalization of CVA risks   Stressed EPE   Wrong-way risk   CCP capitalization rules

  LCR (Liquidity Coverage Ratio): High quality liquid assets (“HQLA”) vs. expected cash outflows in a 30-day stress scenario

  NSFR (Net Stable Funding Ratio): Available vs. required amount of stable funding

  Principles for sound liquidity risk management and supervision

Basel 3 framework   Goal: Improve banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the

source, thus reducing the risk of spillover from the financial sector to the real economy

  Approach: Strengthening of global capital and liquidity rules

Leverage ratio

  Non-risk sensitive measure (Tier 1 capital vs total exposure) to limit the build up of leverage

  Calibration issue: backstop vs. binding constraint

  BCBS: 3% (draft rules)

  CH: 3.1%*

  US: 5-6%

(*) 3.1% is called the “Going-concern loss-absorbing leverage Ratio (TBTF)“ target and is calculated as 24% of the applicable 2019 going-concern loss absorbing capital ratio of 13% under the swiss TBTF regime (Source: SNB, Financial Stability Report 2014)



OTC Derivatives Reform   In Sep 2009, the G20 initiated a reform program to reduce systemic risk from OTC derivatives. The reform

comprised four elements:

  All standardized OTC derivatives should be traded on exchanges or electronic platforms, where appropriate.

  All standardized OTC derivatives should be cleared through central counterparties (CCPs).

  OTC derivatives contracts should be reported to trade repositories.

  Non-centrally cleared derivatives contracts should be subject to higher capital requirements.

CH (FinfraG) EU (EMIR) USA (Dodd-Frank)

  Derivatives regulation rules within DF focus on   Mandatory clearing   Adequate financial resources

for swap dealers   Data collection, publication of

swap repositories

  Rules focus on financial market infrastructure   Mandatory clearing   Risk mitigation / margin

requirements   Trade repositories   Portfolio reconciliation

  Timeline: See Appendix

  Finanzmarktinfrastruktur-Gesetz (“FinfraG”) closely mirrors EMIR   Mandatory clearing   Risk mitigation / margin

requirements   Trade repositories   Portfolio reconciliation

  Timeline: See Appendix



Margin requirements for non-centrally cleared derivatives   In 2011, the G20 agreed to add margin requirements on non-centrally cleared derivatives to the reform program and

tasked BCBS and IOSCO to develop consistent global standards for these margin requirements.

  Result: BCBS IOSCO consultative paper (bcbs261), September 2013

  Timeline: Phased implementation, starts in Dec 2015 (however: No final rules text yet!)

Margin requirements

  Initial Margin (“IM”): Bilateral gross IM posting if outstanding gross notional of non cleared derivatives is above EUR 8bn threshold

  Variation Margin (“VM”): Must be exchanged (zero threshold) on a regular basis, low minimum transfer amounts

  Collateral eligibility: Limited to Cash, high quality government, corporate and covered bonds, equities of major stock indices and gold

Margin protection and re-hypothecation

  Margin protection: Implementation of specific arrangements (including third-party custody) that protect the margin

  “One-time” re-hypothecation of IM: Collateral collected as IM (cash and non-cash) can be re-used at most one time subject to a number of strict requirements.


Collateralized Banking – Situation Today

Basel 3 EMIR

BCBS ETC…

IOSCO

Banks’ reactions to these reforms:

„One of the unintended consequences of the clearing initiative is that it may be transferring systemic risk away from the OTC world into the Repo market. “

„Central clearing essentially switches counterparty credit risk with liquidity risk“

Further reactions range from

„A fair price for safety and transparency“ to


Collateralized Banking – Banks (1/2)

Implications   Collateral matters

  Increased demand for high quality collateral due to:

BC

BS

IO

SCO

+

Bilateral gross IM requirements for non-cleared derivatives, One-time re-hypothecation of IM

Bas

el 3

EM

IR

Dod

d F

+

Liquidity risk requirements (LCR) require banks to hold sufficient high quality liquid assets (“HQLA”)

Posting of margin (IM and VM) to CCPs when clearing derivatives; Mandatory risk mitigation (collateralization) for non-cleared trades

Challenges

  Target operating model for collateral management and optimization

  Re-visit current roles & responsibilities for collateral management (Treasury / FO / Risk / Ops)

  Back-office collateral administration vs. key front-office activity

  Definition & ownership of collateral optimization strategies such as

  Matched-book (Repo) trading;

  Internalization of collateral; and

  Re-hypothecation of collateral received

  Collateral planning activities (under normal and stress conditions), anticipation of collateral demand and supply   Supply / demand imbalance will likely increase

funding costs for high quality collateral assets

  Potential increase in (systemic) risk in stressed markets due to limited collateral fluidity


Collateralized Banking – Banks (2/2)

Implications

Challenges

  Market and business model changes

  Derivatives markets: Future of bilateral OTC markets and evolution of cleared OTC business unclear

  Treasury / funding model: Move away from unsecured funding (punitive under Basel 3/LCR)

  Prime brokerage model: LCR and Leverage ratio requirements put pressure on traditional financing model for hedge funds

  Profitability

  Re-visit product offerings and re-structure (OTC) derivatives trading desks accordingly

  Re-visit service offering

  Prime Brokerage offerings

  Collateral transformation services

  Selection of and focus on “right” client base

Collateral is fundamentally changing the way how banks operate !!!

  IT infrastructure enhancements

  Operational complexity (B3, EMIR/FinfraG, BCBS-IOSCO)

  Not the focus of this presentation


Collateralized Banking – (Re)Insurers, Pension Funds, Corporates (1/2)

Implications

Challenges

  Increased (hedging) costs

  Provision of margins (IM and VM) for cleared and non-cleared OTC derivatives

  2013 BNY Mellon Survey (see Appendix)

  Cost-efficiency #1 (collateral optimization)

  Increase quality of investment portfolio

  Conversion of assets from investment portfolio into eligible collateral

  Establishment of securities financing / Repo desk

  Amplification of margin calls amounts

  Amplification effects for long-dated trades: E.g. Liability-driven investment (“LDI”) hedging portfolios with long-dated IR swaps can trigger large VM calls due to high IR sensitivity

  Additional amplification effects in stressed market conditions

  Cost-efficiency #2 (ALM strategy)

  Re-visit current ALM hedging strategies, rebalancing of existing hedging strategies

  Limit use of swaps and exploit alternative forms of duration


Collateralized Banking – (Re)Insurers, Pension Funds, Corporates (2/2)

Implications

Challenges

  Increased liquidity risk

  Holding of additional liquidity / cash to cover margin requirements

  Access repo market to fund VM calls for (cleared) swap portfolios

  Transformation of counterparty credit risk into liquidity risk; reliance on functioning of Repo markets

  Liquidity risk management:

  Planning of liquidity /funding needs for IM and (potentially large but expected) VM calls

  Stress testing and scenario analyses to assess effects of (large and unexpected) VM calls under stress scenarios and impact on liquidity reserves

  Operational complexity (EMIR, FinfraG)   Achieve compliance with EMIR requirements


Collateralized Banking – Hedge Funds

Implications

Challenges

  Changes to Prime Brokerage model

  Basel 3 impact

  Leverage Ratio: LR requirements* and balance / sheet pressure lead PBs to provide margin loans to hedge funds with less leverage

  Liquidity requirements: LCR, NSFR put pressure on the tradional financing services offered by PBs (maturity transformation**).

  Pricing / cost implications:

  Execution of highly levered strategies will become more expensive (e.g. Fixed income arbitrage strategies)

  Adapt to new PB financing model

  Achieve cost efficiency under the new PB funding model

  Re-visit trading strategies and adapt or abandon cost inefficient strategies

  Accept more risk?

  Shorter term financing,

  Early termination clauses; or

  less leveraged trades / more risky strategies (if you can no longer get the financing/leverage necessary to make an attractive return on less risky arbitrage strategies).

(*) Securities Financing transactions (“SFTs”) are expensive under the Basel 3 Leverage Ratio as SFTs are considered gross (i.e. no recognition of collateral) and with only limited possibility for netting.

(**) 30, 60 or 180d financing to hedge fund clients, funded in overnight repo market or by internalization through re-hypothecated client securities (e.g. use long securities of one client to cover shorts of another client).


Summary

…means collateral matters (!)   Collateral fundamentally changes the way how financial institutions operate   Collateral optimization – a must for banks / an opportunity for (re-)insurers, pension funds

…brings a lot of challenges   Unclear implication of changes in OTC market dynamics   Adaption of business models / strategies to stay competitive / achieve cost efficiency   Infrastructure enhancements / increased operational complexity

… but also opportunities   Securities lending: Attractive opportunities for buy side (insurance companies, pension funds,

corporates) to enhance yields by establishing / extending securities lending activities   Brokerage service offerings: Top players will be able increase market share as smaller players are

forced to reduce / close their brokerage business in order to save costs

Post-crisis collateralized banking…

Thank you!

Dr. Matthias Degen Senior Manager

Financial Services, Quantitative Finance Group KPMG AG Badenerstrasse 172 CH-8026 Zürich

[email protected] +41 58 249 40 36


Appendix – EMIR / FinfraG timelines

Q3 Q4

2013

Q1 Q2 Q3 Q4

2014

Q1 Q2 Q3 Q4

2015

Q1 Q2 Q3 Q4

2016

July 2015* Clearing obligation

Category 1

1 Dec 2015* Variation margin applies and phase-in of initial margin: 1 Dec 2015: EUR 3tn 1 Dec 2016: EUR 2.25tn 1 Dec 2017: EUR 1.5tn 1 Dec 2018: EUR 0.75tn 1 Dec 2019: EUR 8bn

15 Sep 2013 Portfolio reconciliation Portfolio compression

Dispute resolution

January 2018* Clearing obligation

Category 3

July 2016* Clearing obligation

Category 2

Q1 Q2

2017

Early Jan 2015* Clearing obligation regulatory

technical standards (“RTS”) enter into force

(*) Expected development timeline

3 Sep 2014 Federal Council adopted

dispatch on FinfraG

EU (EMIR) CH (FinfraG)

4Q14 / 1Q15 Treatment in Swiss Parliament

12 Feb / 11 Aug 2014 Reporting to

Transaction Register


2013 BNY Mellon Survey

  Participants:

  84 insurance companies; 75% had operations in Europe, 49% in the Americas

  70% had life operations, 58% had non-life operations, 24% reinsurance business

  Gross premiums: 34% > $10bn, 46% < $2.5bn

  Assets: 37% > $100bn, 42% < $25bn

Source: BNY Mellon, Collateral Management Survey 2013

  Key results:

  75% use derivatives to manage IR or FX risk

  48% don’t post initial margin today

  61% pledge their investment portfolios as collateral

  56% do not hold enough assets of required quality in their investment portfolios to support both cleared and OTC trades today

Back


Appendix – Literature

  BNY Mellon (2013), Collateral Management Survey 2013, Reserach paper

  ESMA, EBA, EIOPA (2014), Draft regulatory technical standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012, Consultation Paper, 14 April 2014

  ESMA (2014), Clearing Obligation under EMIR (no. 1), Consultation Paper, 11 July 2014

  Hartl et al. (2014), Collateralized Banking – A collateral management approach for post-crisis banking, Whitepaper KPMG Germany

  Kirk et al. (2014), Matching Collateral Supply and Financing Demands in Dealer Banks, Economic Policy Review 20(2)

  Swiss National Bank (2014), Financial Stability Report 2014

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