Thoughts
Driven by scarcity of capital and regulatory impact, the cost of funding and liquidity, already too high, threatens to rise to levels that will simply be unsustainable.
The industry urgently needs real solutions to regain control. Capco believes strongly that cost of funding can be lowered. Much greater efficiency and effectiveness with capital are real possibilities. So is improved business performance. But, to secure real benefits, change will be required.
Funding and liquidity –
reduce the cost without
limiting your business
Executive summary
Coping with the impact of new regulations
– not whether or when but how?
Successfully navigating the tough new funding liquidity landscape is a challenge. It demands clear and robust routes to success. Institutions need to get funding costs down. And they need to assure required liquidity levels without, literally, breaking the bank.
New rules demand new tools
In this paper we propose four next-generation treasury tools. Each is designed to help banks reach their desired goals in the new landscape. They can be applied swiftly to achieve measurable positive impacts and sustainable competitive advantage. The key areas involved are: effective collateral management; business line ALM; pricing the cost of liquidity; focus on new sources of funding. The quantifiable benefits include lower funding costs, reduced liquidity buffer costs, more cost-effective initial product selection and identification of new and sustainable funding sources.
True funding maturity means going
‘beyond compliance’
Capco’s experience confirms that there is a ‘sliding scale’ of funding maturity. Institutions exhibiting the greatest maturity have already gone beyond
understanding of the funding risks drives their asset side selection. In today’s market, that is an enviably competitive position to be in. It is, as our paper shows, also an achievable one.
So why exactly is funding so
challenging today?
The funding shortfall
According to the IMF1, banks globally need to rollover
an estimated $4 trillion of maturing debt in 2011 and 2012 to support their balance sheets. A large part of this debt is government-guaranteed - which will be need to be refinanced at a higher cost as authorities wind-down monetary policy support measures. At the same time, new regulations such as Basel III and Dodd-Frank will impose hard constraints on adequate liquidity buffers and funding portfolios, which is resulting in a multi-trillion financing shortfall for the industry. We briefly explore these factors in more detail below.
Basel III and Dodd-Frank
Treasurers will find it challenging to comply with the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratios (NSFR) set out in the Basel III reforms. A BIS study2 covering 263 banks, has noted
a shortfall of liquid assets of $2.39 trillion for the LCR metric and a shortfall of stable funding of $3.99 trillion in the NSFR metric. In other words, if the
Funding and liquidity – reduce the cost without limiting your business
In the US, introduction of Dodd-Frank is expected to have a similar constraining effect on funding and liquidity. Firstly, initial margin received from clients will be segregated, thus eliminating this source of funding. Secondly, clearing members will be required to post initial margin, which will result in additional uses of funding. It is estimated3 that the introduction
of Dodd-Frank would require an additional $2 trillion of segregated margin posting.
It is clear that Basel III and Dodd-Frank will increase the amount of funding and liquidity banks need to hold. The key question now is whether banks can sustain their current balance sheet size and composition under the new regulations. In our view, this is unlikely. Banks will be forced to de-lever and change their current asset mix, holding more liquid assets in order to reduce the strains on
funding/liquidity metrics.
Central versus local funding
The new regulatory regime is not concerned exclusively with the amount of liquidity held and funding raised. There is also a spotlight both on where it is sourced and where it is held. The FSA’s Individual Liquidity Guidance/Individual Liquidity Adequacy Assessment is a case in point; here, self-sufficiency of UK entities has to comply with the regulation. Funding and liquidity sourced in a parent company offshore is not considered sufficient unless injected into the UK entity for term. This puts further strains on banks that have traditionally operated under a central funding model. It is our view that entity- specific regulations on liquidity and funding will move the emphasis to a decentralized funding model.
The macro funding environment – tough
competition for scarce resources
If banks are to retain their current business mix, then there are two corollaries. Firstly, the amount they will need to raise will go up. Secondly, the funds concerned will need to be held locally. Now we explore the further issue that this will need to be achieved at a time when funding is expensive and competition for funding is high.
Assuming that CDS spreads are reasonably accurate indicators for the cost of raising unsecured cash, then figure 1 on page 4, indicating Sovereign CDS spreads, illustrates the relatively high costs of funding. On top of increasing the cost of liquidity, the
sovereign debt crisis has also made liquidity scarce for two reasons: 1) the sovereign debt crisis has shaken market confidence and reduced the amount of liquidity available in the money markets, 2) banks’ refinancing and balance sheet restructuring efforts are facing competition from government and corporate debt issuance.
Bank CDS spreads (see figure 2 on page 4) paint a similar picture with rising spreads and the cost of liquidity. It is crucial to make two observations here regarding liquidity in relation to sovereign risk: 1) sovereign risk has eroded confidence in the implicit government guarantees behind banks’ liabilities, and 2) it has led to a reduction in the value of government bonds currently being used as collateral. Together, these effects have resulted in further constriction in a bank’s ability to raise liquidity and raise margin calls. This is borne out by the experience of banks encapsulated in figure 3 on page 6, where the percentage of gross debt issued is falling short of the total maturing debt.
200 180 160 140 120 100 80 60 40 20
Jan Mar May Jul
0 France Austria Germany Netherlands 450 400 350 300 250 200 150 100 50 0
Jan Mar May Jul
500 Spain Italy Belgium 3000 2500 2000 1500 1000 500
Jan Mar May Jul
0 Greece Ireland Portugal Sources: Bloomberg L.P. 2000 1800 1600 1400 1200 1000 800 600 400 200 0 450 400 350 300 250 200 150 100 50 0 600 500 400 300 200 100 0 Jan Apr Jul Oct Jan Apr Jul
2010 2011
Jan Apr Jul Oct Jan Apr Jul
2010 2011
Jan Apr Jul Oct Jan Apr Jul
2010 2011 Greece Ireland Portugal Italy Spain Belgium
High-spread euro area Other euro area United Kingdom United States Japan
Sources: Bloomberg L.P.; and IMF staff estimates.
Note: end 2010 asset-weighted spreads for a sample of banks in each economy. High spread euro area countries are Belgium, Greece, Ireland, Italy, Portugal and Spain.
Figure 2. Spreads on bank five-ear credit default swaps (in basic points) Figure 1. Sovereign CDS spreads - 2011
It is becoming more and more apparent that the market cannot support the level of funding demand from sovereigns, banks and other corporates. Hence de-leveraging seems the only feasible course of action.
What can be done?
The situation ahead looks demanding, to say the very least. Yet there are innovative and practical strategies that treasurers can implement to reduce the funding/ liquidity burden. Based on Capco’s experience and expertise in this field, we consider four key approaches below.
Approach 1 - Effective collateral
management and optimization
Overview Collateral management has historically been seen as a back office function, performed primarily to mitigate credit risk. However, the credit crises continue to illustrate that efficient collateral management is an active contributor to business effectiveness, rather than a ‘box tick’ exercise. It entails using inventory and collateral to generate funding and liquidity. This is achieved by re-hypothecating as much collateral as possible and then using margin calls as a funding source. The impact of this approach reduces the cost of funding, while the funding itself is generated within the entity where it is required. This is important under the self-sufficiency standards set by, for example, the FSA.
Business benefits in more detail The business benefit here is, as stated above, primarily to reduce funding costs. (As context, at least two banks we
know of are targeting 1bps on the secured funding books, where the balances are approximately $300bn.) The biggest positive impact is achieved by effective re-hypothecation – which allows banks to use secured
funding rather than unsecured funding / capital. The second order benefit is identification of the cheapest option to deliver collateral on obligations. The economies here can be very significant, given the widely different funding curves between various forms of collateral. The biggest source of savings lies within OTC derivatives CSAs. However, the principle is equally applicable to any obligation which requires collateral in situations where there is a choice to pledge various forms of collateral.
Approach 2 - Line of business
Asset-Liability Management (ALM)
Overview This requires modeling of the asset-liability mismatch for each line of business - thereby
determining the appropriate sources of funding for each business. The businesses themselves are made aware of the different funding costs associated with each asset type and the term required for each. This interaction helps reduce any inefficient balance sheet usage and is intended to optimize funding sources.
Business benefits in more detail The direct business benefit here is twofold: lower funding costs together with reduced cost associated with liquidity buffers. In short, if the institution can effectively determine the appropriate funding sources and term for each business, then it can more effectively tailor specific funding programs to meet the requirements of that business. The end goal is to increase alignment of funding programs with the business needs. This avoids incurring ‘funding leakage / excessive funding costs’, as well as more effectively
Figure 3. Bank debt issuance as a percentage of maturing debt, 2011
Debt matured (to end-August) Remaining debt to mature Gross debt issued (to end-August)
Sources: Dealogic; and IMF staff estimates.
Note: for presentational purposes, the chart maximum is set to 100.
100 Finland Netherlands France Japan Italy Austria United Kingdom Greece Spain Portugal United States Germany Belgium Luxembourg Ireland 0 20 40 60 80
hedging refinancing risks, which will in turn enable reduction in the amount of liquidity buffers that need to be maintained.
Once built, a robust ALM risk tool allows forward projection of the funding and excess liquidity required within various ‘stressed’ scenarios. This brings the ability to model the effects on funding if there is a) change in the asset composition, as well as b) if certain funding trades do not roll-over, mature, or change collateral eligibility.
Approach 3 - Funding and liquidity risk
pricing
Overview Another innovation is introduction of the pricing of liquidity risk and subsequent passing of that cost back to the businesses. This takes the same form as CVA and is a key factor in driving asset side selection within the front office. The impacts of this approach are twofold: businesses will be accountable for the funding they consume; and the high costs of funding can be priced into transactions and then passed back to clients.
Business benefits in more detail The business case for this approach is better business selection. The idea is that giving the front office an accurate and transparent view of the cost of funding for their business will enable them to make much more informed and better quality decisions. Simply put, by knowing what costs are incurred when buying different products, the best product can be chosen far more effectively.
Approach 4 – Identifying new sources of
funding
Overview Increasingly, organizations are conscious of where they raise financing and from whom they raise it. The most profound change in choice of sources of funding will most likely be a marked diminution in bank cross-selling of debt, as this route is subject to punitive treatment under Basel III.
Business benefits in more detail As an alternative for the future, treasurers will focus on attaining real money, from diverse sources, and for term. As they do so, increased reliance on collateralized funding will be paramount, because the unsecured space will be dominated by sovereign issuances. In this context, banks will be focused on reducing unencumbered assets, attempting instead to utilize them to generate secured funding trades. This will serve two purposes: firstly reduction of cost of funding; and secondly tapping into new sources of funding by providing clients with secured products. The business case here is, once again, effective control of funding costs. The idea is that, as funding from traditional sources is scarce and therefore becoming increasingly expensive, competitive advantage can be gained either by exploiting new sources of funding, or though creation of new and innovative funding products. These approaches are ultimately aimed at actually sourcing funding, as well as reducing the costs of doing so.
Regulatory driven Centralization driven Risk management optimized Risk pricing optimized
Description Most firms belong to this bucket. Agenda and budgets driven by regulatory ‘must haves’.
Have centralized collateral and funding management across OTC and Repo.
Optimize all sources and uses of inventory and collateral across entitles and businesses.
Accurately price the funding liquidity costs.
How is collateral managed?
Optimize silos of collateral pools (for example cheapest to deliver on OTC).
Optimize by a central desk, across entity and derivatives silos.
Same as the centralization model but includes BP, stock loan.
No change.
How is funding managed?
Policy set by Group Treasury. Secured funding is done by a Repo desk in the IB, while unsecured is run by treasury. Certain businesses (PB, stock loan) may also self fund.
Secured funding is centralized with one funding desk . The main tool to determine future funding needs is Funding Risk Tool.
Same as the centralized model, however Funding Risk is expanded to include OTC derivatives, CCP funding and BP.
Using Funding Risk tool, firms begin to develop internal funding tradeables between a central funding desk and business units.
How is liquidity managed?
Using static liquidity which are not sensitive to changes to assets (funding term, composition changes, etc.) or cash.
Secured funding risks are dynamic and measured using funding risk tool which links assets to liabilities.
Liquidity risks for OTC, CCP, and the PB business are measured using Funding Risk Tool and are therefor dynamic.
No change.
How is Funding Risk calculated?
Reliant on FSA 048/047 which fails to adequately measure collateral optionality.
Using ALM matching algorithms to measure Funding risk is a key differentiator for firms in the bucket.
CSA’s and CCP collateral optionality is incorporated into funding risk metrics.
Wrong way correlation and counterparty credit risks are identified in funding risk.
What are the regulatory actions?
Substantial amount of time spent on data quality issues and reporting / transparency.
Through Funding Risk Tool, firms are able to demonstrate more robust funding liquidity metrics and therefor lower the required liquidity buffer.
Funding Risk is used as the key metric versus funding term requirements.
No change.
How is funding managed inter-entity?
Unsecured funding is done at the Group level while secured funding is done in the broker dealer. However firms struggle to prove that entities are self sufficient.
Through inter-company repo , however, in order to proof self-sufficiently, Funding Risk is used.
Same as centralized model , but includes OTC, PB, cleared derivatives.
No change.
How is risk pricing done?
CVA desk prices counterparty credit risks, while funding risks are done using legacy FTP methodologies from treasury or finance.
Collateral optionality in CSA’s and tri-party funding agreements are priced into trades.
Same as centralized model. FVA is introduced across the bank and managed similarly to CVA.
Benefits of reaching this stage
Regulatory compliance Cheaper funding costs Lower level of excess liquidity pools Enhanced FSA reporting on
secured funding books
The funding risk tool is extended to include all products and hence further reduced funding costs and excess liquidity
Asset side selection is based on full understanding of funding risks
Benchmarking funding risk maturity
There can be no doubt now that an effective response to the new regulatory environment is a question of how, rather than ‘if and when’. The approaches we outlined above can and will make a positive difference to an institution’s funding generation and liquidity management capabilities. It is however very useful to know where each institution stands in terms of specific progress towards improvement. Figure 4 on page 8 captures Capco’s own funding risk maturity model and the key stages on the journey to an optimized approach.
The maturity journey – from ‘bare
bones’ compliance to full
comprehension of funding risk
We have defined four key stages on the maturity journey. At each of the three stages after the most basic – ‘regulatory driven’ – progressive improvements can be observed in approach to the key activities of collateral, funding and liquidity management, funding risk calculation, regulatory interaction, inter-entity funding management and risk pricing.
Stage 1 ‘regulatory driven’ Institutions that remain ‘regulatory driven’ (and they are currently in the majority) achieve compliance, certainly. Yet they miss out on significant opportunities to realize the savings and enhanced controls that derive from a more ‘joined-up’ approach.
Stage 2 ‘centralization driven’ Banks which are ‘centralization driven’ are typically more centralized in approach to key tasks and relationships. They benefit
in turn from cheaper funding costs, reduced levels of excess liquidity and higher quality reporting on secured funding.
Stage 3 ‘risk management optimized’ As the description suggests, these institutions extend the ambit of funding risk to include all products, thus securing further reductions in funding costs and excess liquidity.
Stage 4 ‘risk pricing optimized’ This advanced stage of maturity enables asset side selection based on 360° understanding of funding risks.
Time for action
Funding, treasury and liquidity managers need to ask how long their institutions can continue to compete effectively if they do no more than satisfy the rules. A holistic view of funding, liquidity and associated opportunities and risks reveals some key actions. The hottest ‘burning platform’ is the need to move away from a silo approach with major decisions taken, in isolation, by separate business line. There is often a deep need for organizational change. In practice this means identifying key personnel to create a central desk, mandated to tackle major issues on a cross-organizational basis. A single funding desk will have far-reaching front and back office cultural implications. But it also brings significant benefits, not least cost reduction and visibility of consistent and accurate risk information. However, the new state is seldom achieved with today’s infrastructure, operating procedures and
technology. Centralized practice and accurate model building is highly demanding in terms of data quality and availability, improved touchpoints between front and back office functions, and internal reporting protocols and standards. All these elements need to be closely reviewed. If ‘missing’ or below a viable standard, investment is required. The objective is to equip the business to function more sustainably and effectively in the long run.
Conclusion
Basel III and Dodd-Frank are unlikely ever to be welcomed as a silver-lined cloud. But there are clear courses of action that can and should be taken as a matter of urgency. By achieving compliance in ways that do more than obey the basic rules, banks have a very real chance to survive and thrive through the rigors of a financial services new age. New rules do indeed demand new tools. Given the right tools and approaches, compliance really can mean serious competitive advantage.
Footnotes
1. Source: International Monetary Fund, Global Financial Stability Report, 2010
Maurizio Bradlaw is co-lead for Capco’s Capital Markets domain for Europe. He has extensive experience in delivering business and technology solutions to investment and corporate sectors of universal banks, as well as to market infrastructure players. Maurizio excels at acquiring and delivering projects with expertise that covers strategy definition, operational transformation, through to IT realization. He combines solid front to back office and risk management knowledge with excellent technical and managerial skills. He has some twenty years’ experience in the Financial Services industry, and has worked for sell-side, buy-sell-side, corporate and in management consulting.
maurizio.bradlaw@capco.com
Harmen Meijnen is a Partner and co-manager of Capco’s Netherlands business, based in Amsterdam. He plays a leading role supporting Capco’s expertise and experience in the areas of finance, risk and compliance. Over the past 15 years, Harmen has acted as a consultant in the banking, insurance and asset management business domains. His key areas of functional focus and domain expertise include: corporate banking, retail banking and commercial real estate financing; credit, market and operational risk; economic capital management; cost & value management.
harmen.meijnen@capco.com
Valérie Texier is a Partner based in Capco’s Paris office, where she has a leading role in the development of the firm’s capabilities in the Finance, Risk and Compliance (FRC) domain. Valérie has more than 20 years’ experience and deep expertise in the risk management of financial activities, having overseen the design and implementation of global risk-related projects for the risk departments of major French banks and financial institutions operating in an increasingly regulated environment (with the majority of the focus on Basel II and III). Over the past decade, she has worked closely with clients on the deployment of internal models for market, credit and liquidity risk.
valerie.texier@capo.com
Steve Vinnicombe is a London-based partner, focusing primarily on the investment banking and investment management markets. Steve has over a decade of experience in the financial services industry, with a particularly strong expertise in the definition of strategy and target operating models. Steve has partnered with his clients to address challenges in the areas of profitability, regulation, risk, new business growth, capital efficiency, operational productivity and effectiveness. He has led a number of complex change programs and worked in all major financial centers, including London, New York, Hong Kong and Tokyo.
stephen.vinnicombe@capco.com
Thanks also to Ian Rawlinson and Eric Bystrom for their insight and analysis in preparing this document.
Ian is a Managing Principal, in charge of Capco's UK risk capability. He has over 20 years of professional experience. Following a secondment to the Financial Services Authority's policy team, he has assisted many global clients in the development and assurance of their ICAAPs. Ian has also worked in areas as diverse as bank operating model development and design, bank set-up and authorizations, credit risk management, organizational design and technology transformation.
Eric is a Principal Consultant with over five years of experience spanning across areas of corporate treasury, liquidity risk management, funding models and execution, collateral management, transfer pricing, and strategy and engagements. Eric’s significant contributions include enhancing and managing liquidity for a global Tier 1 bank. He also has experience in managing secured tri-party funding and short-term unsecured programs.
About Capco
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