Risk and Collateral M anagement A view from the field Dongdong Zhang 25 April 2013
Collateral management takes on broader missions The importance of collateral management was highlighted during the last financial crisis, regulatory reform will once again put it front and center in banks’ operations • 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 Risk M anagement • 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 Liquidity • Repo market is the main source for short term funding for European bank at €5.6 trillion M anagement (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 New development • 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 2
Collateral management practice in the financial crisis 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 • 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 Reduced the total • $50 billion could be lost to monoline debacle market loss • 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? Some surprises • 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 Overall grade adequacy, liquidity risk and leverage control • Still many good lessons learned 3
What collateral management can not do? 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. • Cushion the loss at the time of default Review of key • Provide liquidity • Serve as a deterrence to counterparty’s overleveraging functions • 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 o fully hedge PFE on top of stress test will stop most of the transactions Constraints • 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 Focus value 4
A good collateral manager, from a risk point of view Collateral management has been a reliable rear guard but now should take on the roles of sentry and vanguard • 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 – Beyond the day to the perils of triple A buy side • Review your assumptions for close-out netting, and review again day • 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 T oolkits • 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 5
Regulatory reforms New regulatory initiatives will make the overall financial system safer but will pose some new challenges as well. • 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 In a nutshell 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 • 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 Impact • 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 out of business earlier if they don’t apply for insurer exemption. But still • T oo many exemptions Back testing • Danger of regulatory “ mitigations” • Danger of regulatory arbitrage • Capital, leverage and liquidity are the keys 6
Regulatory reforms, impact felt on the ground New regulatory initiatives presents different challenges and opportunities, depends on who you are and where you • 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 Sell side • 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 • 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 Buy side • 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 our 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? Long term view • 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 7
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 。
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