Risk and Collateral M anagement A view from the field Dongdong - - PowerPoint PPT Presentation

Risk and Collateral M anagement

A view from the field Dongdong Zhang

25 April 2013

Collateral management takes on broader missions

2

Risk M anagement Liquidity M anagement New development

• OTC derivative market total outstanding at $440 Trillion with gross mark to market value at

$27 Trillion

• Netting reduced the market value exposure by 87.5% globally
• Exposure was further reduced by collateral to 4.1% to 7.7% of market value (BIS -2012)
• Collateral management provided a lifeline to the derivative markets after shocks, crisis and

political backlashes

• US repo market at around $10 trillion. By Fed Estimate $1.75 trillion is tri-party
• Repo market is the main source for short term funding for European bank at €5.6 trillion

(ICM A)

• Asia repo activity is also picking up but lagging far behind other regions
• Various regulatory initiatives drive the changes on capital usage for OTC, Liquidity coverage

ratio, central clearing and mandatory margin calls.

• Increased use of repo/ tri-party repo for liquidity management and risk management
• Regulatory reform leading to more complicated operations will require better tools and

processes to be operationally safe

• All these are under the backdrop of a turbulent financial market hit by rolling crisis

The importance of collateral management was highlighted during the last financial crisis, regulatory reform will

• nce again put it front and center in banks’ operations

Collateral management practice in the financial crisis

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Reduced the total market loss Some surprises Overall grade

• US financial loss of the crisis: 350 banks . Financial sector loss $885 Billion -(IM F)
• The loss attributable to counterparty risks : $2.7 Billion on OTC derivatives
• $50 billion could be lost to monoline debacle
• Overall collateral management did what it was supposed to do
• Did collateral management work too well, to the detriment of AIG? Insurance model vs.

market model

• AAA to Junk
• What is in your collateral?
• A repo counterparty in need…
• We all have good lawyers
• Game of chicken – why some monolines were around for so long
• M ore than passing, much better than other areas such as counterparty risk, capital

adequacy, liquidity risk and leverage control

• Still many good lessons learned

The financial crisis provided a great opportunity to evaluate the effectiveness of collateral management. The back drop is a system wide crisis that threatened all financial institutions

What collateral management can not do?

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Review of key functions Constraints Focus

• Cushion the loss at the time of default
• Provide liquidity
• Serve as a deterrence to counterparty’s overleveraging
• Limited access to market information and operational focus
• M arket volatility can be higher than expected even in PFE - model risk. So it can not fully

cushion the loss. T

• fully hedge PFE on top of stress test will stop most of the transactions
• Relying on repo market for liquidity is a double-edged sword
• Deterrence can work if the other side and their regulators are awake and aware.
• Integrated with the risk management and front office to be more effective and add more

value

Although important, collateral management is just one aspect of the overall risk management. It couldn’t and wouldn’t save Lehman but it prevented delayed a total collapse to give Fed time to respond.

A good collateral manager, from a risk point of view

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Beyond the day to day T

• olkits
• Be aware of the market risk information and be alert of telltale signs such as excessive

disputes, better than normal repo rates offered etc.

• Be prudent on the ISDA/ CSA terms (downgrade triggers and collateral types)
• Stress test your own liquidity and ability to meet margin calls in the worst case scenario –

the perils of triple A buy side

• Review your assumptions for close-out netting, and review again
• Know your front office and become a trusted advisor on collateral sourcing and allocation.

Silo effect creates risks and missed opportunities – some interesting discussions with major banks

• Know your counterparties, and take appropriate actions
• M aturity profile
• Counterparty credit quality, CDS level
• Watchlist of counterparties
• Funding costs and availability of your various assets available for posting
• Expected future mark to market and collateral posting projection per counterparty
• Basic understanding of valuation methodology and sources of disputes
• Basic understanding of PFE, EPE methodology and their limitations

Collateral management has been a reliable rear guard but now should take on the roles of sentry and vanguard

Regulatory reforms

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In a nutshell

• The goal is to reduce systemic risks and increase transparency
• Basel III with G20 endorsement: focus on more stringent requirements on capital, liquidity

and leverage that covers OTC derivatives . LCR and Non cleared trades

• Parallel efforts by US and EU (Dodd-Frank, EM IR) focusing on the detailed rules for central

clearing , reporting and independent margin and variation margins.

• Outside of US and EU, individual countries have their own regulatory platforms
• Timelines are all delayed or phased

New regulatory initiatives will make the overall financial system safer but will pose some new challenges as well.

Back testing Impact

• The initiatives are achieving the goals set out.
• Negative impacts on liquidity, cost. Some caveats for CCP and M argins
• End user exemption for sovereign, pension , corporate, insurer (is AIG exempt?)
• Phased implementation
• Covered transactions exemptions (it surely covers standard IRS, which is 53% cleared

even without regulation – ISDA survey)

• Threshold for IM , further discussions on collateral types
• Exemptions on capital are more stingily given
• On face value, the OTC regulations will not avert the last crisis but could drive monolines
• ut of business earlier if they don’t apply for insurer exemption. But still
• T
• o many exemptions
• Danger of regulatory “ mitigations”
• Danger of regulatory arbitrage
• Capital, leverage and liquidity are the keys

Regulatory reforms, impact felt on the ground

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Sell side

• M any concerns, capital charge and IM ranked high based on our discussions with them
• Capital charge for un-cleared and uncollateralized trades are very high. Default risk +

Stressed VaR for CVA vs. 0-2% for cleared trades with QCCP - Affects pricing

• Independent margin based on worst case PFE leads to excessive cost outweighing potential

benefits of risk reduction. Balance sheet rationalization

• Lose advantages over lower rated counterparties on CSAs
• Some banks are retreating from the OTC derivative business

New regulatory initiatives presents different challenges and opportunities, depends on who you are and where you

Long term view Buy side

• Even if you are exempt from these regulations, your counterparties may not be. Capital

charges exemption were even less generous so far - Be aware of overcharging

• Sorting out which jurisdiction you are dealing with and follow all the new updates on

regulations

• Needs to stress test liquidity and capital positions with the assumption of multi-notch

downgrade coinciding with the worst mark to market

• T

end to have one-sided exposures and reduced access to repo market

• Y
• ur high quality sovereign paper may be in demand in a collateral squeeze
• Neither a watered-down regulatory reform nor an overly restrictive regulatory environment

is good for the market participants. A balance will be reached but should be alert about the too generous phase-ins – remember Basel II?

• The central clearing is in fact a market driven initiative given its 150% increase since 2007, in

the backdrop of a stagnate derivative market. It could transform the market to standardize transactions, lower credit risk and eventually lead to lower costs for all participants

Thank you!

谢谢！

Disclaimer The analysis and opinions expressed in this presentation are those of the authors and do not represent the official position and views of the ADB, its Board of Directors and the countries they represent.

声明 本发言仅代表作者本人的意见和观点，并不反映亚洲开发银行，及其董事会和亚 行成员国的看法和立场。