The challenge of liquidity and collateral management in the new regulatory landscape

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1 The challenge of liquidity and collateral management in the new regulatory landscape ICMA Professional Repo and Collateral Management Course 2012 Agenda 1. Background: The repo product under pressure 2. New regulatory landscape: Example Basle 3 3. The challenge for a repo trader 4. Conclusion 2 1

2 Repo man - Abstract : Otto Maddox, a young punk rocker gets fired from his boring job as a supermarket stock clerk. Depressed and broke, Otto wanders the streets, until he falls in with Bud a seasoned repossession agent, or "repo man", working for a small automobile repossession agency. Although Otto is initially disgusted by the concept of repossessing cars, his opinion changes rapidly when he is quickly paid in cash for his first "job". Otto soon learns that the life of a repo man is always intense." Source: Wikipedia 3 Lehman s Repo 105 (simplified presentation) Accounting treatment of repos In most cases repo transactions remain on the balance sheet being classified as loans. However, Repos can also be treated as sale of assets if the bank receiving the loan does not retain control over the securities (Repo 105 maneuver). Lehman s accounting procedures Lehman entered into repo transactions giving collateral worth 105% of the cash they received. Repos were classified as sale, showing a significantly reduced balance sheet. (US GAAP) Reduced Leverage Lack of transparency Short term liquidity management insufficient 4 2

3 MF Global Repo-to-maturity MF Global entered into repo transactions where the end date of the repo is equal to the maturity of the bond. When the bond matures, the cash provider receives the final payment directly from the issuer of the bond. He passes the final payment minus repo interest minus repo loan amount on to MF Global. Risk Margin calls if market value of the collateral falls during the lifetime of the repo Accounting Repo-to maturity can be treated as off balance sheet items Reduced Leverage Lack of transparency Short term liquidity management insufficient 5 How did the market react - short term? Limited liquidity in the money market - cash providers moved into secured funding Central bank actions increased the demand for top collateral by banks Real money accounts increased buying of government paper and do not repo it out Hedge funds and banks accelerated deleveraging Triparty business and repos in lower rated asset classes decreased Agency lenders reduce / stop their repo activities Diversification of the repo collateral market (e.g. no longer one GC repo market in Europe) Haircut models were revisited 6 3

4 How did the market react - medium term? 1. Improvements in the internal liquidity management processes 2. Changes in the maturity profile of repos (evergreen structures) 3. New trade types (e.g. evergreen structures, upgrade /downgrade trades) 4. Trend towards centrally cleared transactions 5. Revised risk policies of the central counterparties 6. Non -banks entered the repo market 7 Keynote speech by Sharon Bowles MEP on shadow banking (chair - committee on Economic and Monetary Affairs) April 27, 2012 There has been a lot of interlinkage between the banking sector and shadow banking activity, and the scope for asymmetry of information that exists in the shadow sector was transmitted into - or used by - banks. Indeed it is one of those ironies that banks simultaneously complain about competition from shadow activity yet seem to have made use of it so extensively! Banks created, sold or repo'd the alphabet soup of CDS, ABS, CDO and MBS assets. Many of these came into existence as a pure arbitrage: bundling together future profits in the form of a positive interest rate carry and netting the profits today. Source: 8 4

5 Agenda 1. Background: The repo product under pressure 2. New regulatory landscape: Example Basle 3 3. The challenge for a repo trader 4. Conclusion 9 Understanding the Regulator s Perspective of Basel III Cash markets are fragile and can disappear quickly Too much maturity transformation is unhealthy for the financial system Interconnected financial sectors can collapse like a house of cards There is good banking business (loans, deposits, service real economy) There is bad banking business (prop trading, derivatives) 10 5

6 Basel Committee on Banking Supervision reforms - Basel III Capital Pillar 1 Pillar 2 Pillar 3 Capital Risk Coverage Leverage ratio Risk management and supervision Market discipline (reporting) Liquidity Pillar 1 Pillar 2 Pillar 3 Liquidity Coverage Ratio (LCR) Net stable funding ratio (NSFR) Principles for Sound Liquidity Risk Management and supervision Supervisory monitoring Source 11 Minimum ratio for short term liquidity Goal: Promoting short-term resiliency by ensuring that institutions survive a stress scenario lasting for one month Short term: Liquidity Coverage Ratio (LCR) Stock of high-quality liquid assets Total net cash outflow over the next 30 calendar days 100% LCR identifies the amount of unencumbered, high quality liquid assets that can be used to offset net cash outflows under stress 12 6

7 Stock of high-quality liquid assets (numerator LCR) High quality liquid assets Level 1 assets (can be included without limit) Level 2 assets (can only comprise up to 40% of the stock) Operational aspects The assets must be unencumbered (not pledged) The stock should be under the control of the specific function or functions charged with managing the liquidity risk of the bank (typically the treasurer) 13 Level 1 assets Marketable securities representing claims on or claims guaranteed by sovereigns, central banks, non-central government PSEs, the Bank for International Settlements, the International Monetary Fund, the European Commission, or multilateral development banks and satisfying all of the following conditions: assigned a 0% risk-weight under the Basel II Standardised Approach; traded in large, deep and active repo or cash markets characterised by a low level of concentration; proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions; and not an obligation of a financial institution or any of its affiliated entities. 14 7

8 Level 1 assets (II) Cash Central bank reserves, to the extent that these reserves can be drawn down in times of stress for non-0% risk-weighted sovereigns, sovereign or central bank debt securities issued in domestic currencies by the sovereign or central bank in the country in which the liquidity risk is being taken or in the bank s home country; for non-0% risk-weighted sovereigns, domestic sovereign or central bank debt securities issued in foreign currencies, to the extent that holding of such debt matches the currency needs of the bank s operations in that jurisdiction. 15 Level 2 assets Marketable securities representing claims on or claims guaranteed by sovereigns, central banks, non-central government PSEs or multilateral development banks that satisfy all of the following conditions: assigned a 20% risk weight under the Basel II Standardised Approach for credit risk; traded in large, deep and active repo or cash markets characterised by a low level of concentration; proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions (ie maximum decline of price or increase in haircut over a 30-day period during a relevant period of significant liquidity stress not exceeding 10%); and not an obligation of a financial institution or any of its affiliated entities. A minimum 15% haircut is applied to the current market value of each Level 2 asset 16 8

9 Level 2 assets (II) Corporate bonds and covered bonds that satisfy all of the following conditions: not issued by the bank itself or any of its affiliated entities (in the case of covered bonds); assets have a credit rating from a recognised external credit assessment institution (ECAI) of at least AA-12 or do not have a credit assessment by a recognised ECAI and are internally rated as having a probability of default (PD) corresponding to a credit rating of at least AA-; traded in large, deep and active repo or cash markets characterised by a low level of concentration; and proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions: ie, maximum decline of price or increase in haircut over a 30-day period during a relevant period of significant liquidity stress not exceeding 10%. 17 Denominator: Net cash outflow (defined as Cash outflow Cash inflow capped at 75%) REPO & SEC LENDING ITEM Secured funding transactions backed by level 1 assets, with any counterparty Secured funding transactions backed by level 2 assets, with any counterparty SecFund transactions backed by assets that are not eligible for the stock of highly liquid assets, with domestic sovereigns, domestic central banks, or domestic PSEs as a counterparty All other secured funding transactions CASH OUTFLOW (repos and securities lending) Factor (to be multiplied against total amount) 0% 0% 15% 15% 25% 100% 100% CASH INFLOWS (reverse repos and securities borrowing) Factor (to be multiplied against total amonunt) Source: BIS- BCBS

10 Denominator: Net cash outflow Money Market CASH OUTFLOW ITEM Description Factor (to be multiplied against total amount) Retail deposits with residual maturity or notice period within 30 days - stable deposits Minimum 5% - less stable deposits Minimum 10% Unsecured wholesale funding with residual maturity or notice period within 30 days - stable small business customers Minimum 5% - less stable small business customers Minimum 10% - Non financing corporates, sovereigns, central banks and PSEs 75% Other legal entity customers 100% Source: BIS- BCBS Agenda 1. Background: The repo product under pressure 2. New regulatory landscape: Example Basle 3 3. The challenge for a repo trader 4. Conclusion 20 10

11 Example Liquidity Coverage Ratio Impact on different product types on identical balance sheets: liabilities 30 one week repo on Government Bond Outflow 0 liabilities 30 one week repo on ABS Bond Outflow months IB MM Outflow 0 40 O/N retail (stable) Outflow 2 but 30 O/N IB MM 40 3 months retail (stable) Outflow 30 Outflow 0 assets 50 Government Bond Buffer 20 1) LCR 1000% assets 50 Government Bond Buffer 50 LCR 83% 50 ABS Bond (illiquid) Buffer 0 1) Only 20 units unencumbered since 30 funded via repo 50 ABS Bond (illiquid) Buffer 0 No credit for short term secured funding of illiquid securities No credit for short term wholesale (interbank) funding 21 Banks will have to transform the structure of their balance sheets Assets Liabilities Assets Liabilities Liquid Assets Reverse Repo Equity Borrow Equity, Fin s Corp. Bonds Short term loans Equity Money Market Repo Equity Lending Customer Deposits Liquid Assets + Equity Borrow - Reverse Repo - Equity, Fin s Corp. Bonds Short term loans + - Equity + Money Market - Equity Lending - Repo - + Customer Deposits Long term loans Derivatives receivables Capital Market Derivatives payables Long term loans - Derivatives - Capital Market Derivatives + - with target function to optimize (all) regulatory ratios under the boundary condition to remain profitable 22 11

12 Challenges ahead 1. Clear separation of market for collateral Collateral Level 1 / Level 2 eligible vs illiquid (illiquid includes equity) 2. High-liquid assets on the balance sheet increase (liquidity buffer) Less collateral for the repo / seclending market 3. Excess high- liquid assets need to be pooled in the treasury department Identify all your collateral not used and hidden in the boxes 4. Matched books reduced (leverage ratio, no credit for illiquid assets) 23 Challenges ahead (II) 1. More capital needed for the European banking industry Source? Impact on RoE? 2. Banks retreat from some businesses Liquidity in the bond market? 3. Banks amend their business models No interest in seclending market? 4. Hedging is getting more expensive Impact of expensive credit valuation charges? Shadow Banking 24 12

13 Agenda 1. Background: The repo product under pressure 2. New regulatory landscape: Example Basle 3 3. The challenge for a repo trader 4. Conclusion 25 Important aspects for a financing trader before trading Collateral (Rating, Issue Size, Liquidity) Counterparty (Credit line, Cash out limit, CCP) Re- Use Haircut Balance Sheet Pricing 26 13

14 Peter Schmidt Head of Secured Funding / Treasury Tel.: Mail: Office: Mainzer Landstr Frankfurt/Main Postal address: Frankfurt/Main Tel.: Mail: 14

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