RBI curbs offshore lending

Reserve bank of India has banned oversees branches and subsidiaries of Indian banks from providing dollar funding and issuing any kind of credit facilities if this funding is going to be used to refinance the rupee debt. Since June 2012 lot of infrastructure and manufacturing companies raised money offshore to convert their high cost rupee loan to low cost dollar loan.

Indian rules do not allow refinancing of rupee loans with foreign debt. However, in June 2012, manufacturing and infrastructure companies were granted an exemption as onshore interest rates spiked.
The fact that domestic Indian banks still back new loans, however, seems to have raised a red flag for the regulator, and the notice sends a clear sign that offshore refinancing will only be allowed if it does not involve additional liabilities for Indian banks.
“If the [external commercial borrowing] is availed from overseas branches/subsidiaries of Indian banks, the risk remains within the Indian banking system. It has, therefore, been decided that repayment of rupee loans through ECBs extended by overseas branches/subsidiaries of Indian banks will, henceforth, not be permitted,” the notice said.

Because of this decision lot of deals will be impacted. Now refinancing will happen onshore or this ban can be victory of international lenders who now will have upperhand in obtaining new business.

Market analyst believe that  RBI’s move to have an impact on the syndication of several financings in the market that feature SBLCs (Stand by letter of Credit) from Indian lenders.

Comprehensive Capital analysis and review, March 2014

The Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR) is an intensive assessment of the capital adequacy of large, complex U.S.bank holding companies (BHCs) and of the practices these BHCs use to manage their capital. This process helps ensure that these BHCs have sufficient capital to withstand highly stressful operating environments and be able to continue operations, maintain ready access to funding, meet obligations to creditors and counterparties, and serve as credit intermediaries.

 In November 20111, The Federal Reserve adopted the capital plan rule , which requires BHC (Banking holding companies) with consolidated assets of $50 bn or more to submit the annual capital plans to the Federal reserve for review.
In the submission Fed expects following detailed description for BHC's following-

1)  Internal processes for assessing capital adequacy
2) Policies governing capital actions such as common stock issuance, dividends, and share repurchases
3) All planned capital actions over a nine-quarter planning horizon.
4) Thee results of stress tests conducted by the BHC under a number of scenarios (company-run stress tests) that assess the sources and uses of capital under baseline and stressed economic and financial conditions.
 Annual CCAR exercise completed by the Federal Reserve for 2014.The 30 BHCs that are part of this year’s CCAR hold 80 percent of the total assets of all U.S. BHCs. The amount and quality of capital held by these institutions have continued to improve, contributing to increased resilience of the banking sector and a strengthening of the financial system more broadly.

The aggregate tier 1 common equity ratio of the 30 BHCs in the 2014 CCAR has more than doubled from 5.5 percent in the first quarter of 2009 to 11.6 percent in the fourth quarter of 2013.1 That gain reflects a total increase of more than $511 billion in tier 1 common equity from the beginning of 2009 among these BHCs to $971 billion in the fourth quarter of 2013. BHCs have raised equity from external sources, including the equity raised in connection with the redemption of U.S. government investments under the Troubled Asset Relief Program and requirements to raise capital following
the SCAP in 2009. Much of the additional increase in recent years is attributable to a significant
accretion of common equity through retained earnings as capital growth has been supported by
general improvements in profitability across the banking system.

  

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Latest NDF Market developments

Key points about NDF market and how it is related to "on shore deliverable market" from "NDF market 2013 and beyond" , A report in BIS quarterly review report.

Non-deliverable forwards (NDFs) are contracts for the difference between an exchange rate agreed months before and the actual spot rate at maturity. The spot rate at maturity is taken as the officially announced domestic rate or a market-determined rate. The contract is settled with a single US dollar payment. Thus NDFs yield payoffs related to a currency's performance without providing and requiring funding in the underlying currencies as do deliverable forwards.

Non-deliverable forwards (NDFs) allow investors and borrowers to take positions in currencies that are subject to official controls. Turnover in NDFs has risen in recent years as non-residents use them to hedge increasing investment in local currency bonds

• By analyzing the relationship between the prices of NDFs and deliverable forward, the feature find that the segmentation between deliverable forward and NDFs is evident .
• The NDF market tends to lead the domestic market, especially in stressed periods.
• NDF market tends to fade away after the liberalization i.e.  AUD
• The latest Triennial Survey reported $127 billion in daily NDF turnover. This represented 19% of all forward trading globally and 2.4% of all currency turnover. Almost two thirds took place in six currencies against the dollar. Like forward markets and emerging market currencies in general, a very high share of NDF trading (94%) takes place against the dollar.
• Segmentation is strongest in the Indian rupee, followed by the renminbi, the Brazilian real, the Korean won, the New Taiwan dollar and finally the Russian rouble.
• NDF turnover grew rapidly in the five years up to April 2013, in line with emerging market turnover in general (Rime and Schrimpf (2013)). Following Bech and Sobrun (2013).
• Lot of money has been invested in the emerging market i.e. government bonds, capital investments. Investor use NDF market to hedge their exposure. In fact lot of emerging market firms raise capital across the world especially in USD and Euro so these firms also used NDF market to hedge the exposure.
• In August 2013, INR was highly volatile and on shore deliverable market was driven by the off shore NDF market. Central bank has very limited means to control the NDF market so RBI is still discussing on how to bring that market onshore.

How do NDF markets evolve -    

Two different paths for the evolution of NDF markets can be distinguished. First, if non-residents are allowed to buy and sell forwards domestically - in effect, to lend and to borrow domestic currency - such liberalisation makes an NDF market unnecessary. But the NDF market does not necessarily go away immediately. Second, if restrictions remain, the NDF persists. However, markets can still develop based on the NDF.

One example of the first path is the Australian dollar. Debelle et al (2006) tell the surprising story of the slow passing of the Australian dollar NDF. Deliverable forwards opened up in 1983, but the NDF continued to trade, lingering until 1987.

The NDF share of trading in the rouble has declined even more gradually. The Russian authorities made the rouble fully convertible in mid-2006 amid current account surpluses, large foreign exchange reserves and ambitions for its international use. Since then, the London data show that NDFs fell from 75-80% of forwards in 2008 to about half in April 2013. Especially given the bounce of the NDF share back to more than 60% in October 2013, the rouble NDF could linger for 10 years after its liberalisation in 2006.

Korea has been more cautious in removing the complete restriction on Won currency trading. The ability of Korean banks in trading both the NDF and onshore market keeps both market tightly coupled.

The Renminbi is not travelling either path. Certainly, the Chinese authorities have not allowed unrestricted non-resident access to the onshore forward market. Instead, they have permitted, within still effective (although leaky) capital controls, a pool of renminbi to collect offshore that can be freely traded and delivered offshore (Shu et al (2013)). A three-way split of the renminbi forward market has resulted, with an onshore market (dating to 2006), an offshore NDF market (dating back to the 1990s) and an offshore deliverable, or CNH, market (since 2010).

The NDF market will continue to grow faster than the foreign exchange market as long as authorities try to insulate their domestic financial systems from global market developments, albeit at the cost of lower liquidity. The insulation, however, can seem pretty thin at times. When NDFs serve as a main adjustment valve for non-resident investors in local assets and local firms with dollar debt, they can lead domestic markets.
  
 

Credit Default Swap - I

Credit default swap is one of the most traded product.  CDS , CDS indices , CDS swaptions  have become very important tool for banks to hedge their counter party risk. To reduce the earning volatility driven by CVA, banks uses CDS or CDS indices.

Basics of CDS -

1) When someone buy CDS then it means that he has bought the protection on credit risk of reference entity. Buyer will pay the agreed premium to the seller. Buyer will have to pay this premium until expiry of trade or if credit event occurs.

2) Seller of CDS buy the credit risk of  reference entity and he will earn premium from the buyer of CDS. Seller has to pay the (1-RR)*notional amount to buyer if credit events occurs.

3) Seller of CDS makes profit if spreads tightens on the reference entity and buyer will be losing the same amount of money by spreads tightens.

4) Spreads are normally based on one reference rate i.e. Libor. CDS spreads are very tightly coupled with bond spreads. Market Quotes of premium of liquid CDS are driven by the arbitrage relationship with bond spreads rather than from any model.

Motivation for trading CDS-

1) To hedge the counterparty risk
2) Market maker buy and sell CDS to earn the spreads.
3) To exploit the arbitrage between bond spreads and CDS spreads though these markets are closely related because of active arbitrage traders.
4) Index skew trading or to earn spreads between on the run and off the run issues.


Any derivative or structured product can be best understood if you can replicate risk and return profile of this product with simple products. CDS can be replicated using the bond that is funded by the borrowing.

CDS is not a funded product as buyer do not have to pay the notional amount of the CDS to the seller but bond is the funded product so to replicate the CDS with the bond, bond has to be bought using the borrowed money.

To replicate a CDS (selling protection, for example) using bond market instruments, we can buy a par floating rate note or an asset-swapped fixed-rate par bond1 and borrow money to fund the purchase. The resulting risk profile of this package is similar to that of a CDS: long credit risk with interest rate risk hedged (there are, however, certain differences, which we illustrate at the end of this section). The resulting cash flow profile is also similar.

However there are certain subtle differences in these two. More on this is explained in Credit Default swaps.  Arbitrage relationship also depends on the funding cost of the firm as different firms have different funding cost because of their creditability. CDS spreads of a distressed entity do not directly related to bond spreads of that entity. We will discuss both the points in next post.

 

Historical Simulation VaR

This is first post in series of implementation of VaR in banks. Almost three fourth banks uses the historical simulation rather parametric or Monte Carlo methodologies for calculating bank's VaR numbers. It is not that this is best method to calculate the VaR or it captures risk correctly and completely than Why should this be so – what are the advantages of historical simulation over the other two approaches?

1) The main advantage is that historical VaR does not have to make an assumption about the distribution of the risk factor returns. Other methods can incorporate the multivariate distribution and skewed tail risk factors. But in historical simulation method this is assumed that historical returns factored in all these skewed returns and multivariate distribution.

2) It is easy to calculate and less computation intensive compare to Monte Carlo method.

3) Regulators ,Basel committee,  have accepted this method for the calculation of regulatory capital requirement of the bank. Though Basel committee guidelines have other provisions like back testing add-on  of VaR model to capture the risk that can be missing in VaR.

4) This method captures fat tails as fat tails occurs more frequently than it has been assumed.

However there is lot of controversy on using the historical simulation method. Some of the above benefits have been challenged and discussed in the How historical simulation made me lazy paper.

Success of historical method depends upon the underlying historical return that is getting used to calculate the return. Data can be stale or this historical time series may not be making much sense in today's time due to change in economic scenario (expansion or decline) , volatility , regulation change.

Various flavor of historical simulation has been developed. we will discuss them in subsequent posts.

It was not insolvency but liquidity that collapse entities at least LBIE

Tony Lomas, lead administrator of Lehman Brothers, says LBIE, Lehman London Bank /Dealer, will have £5bn in surplus after liquidation. LBIE has paid or will pay to all its unsecured debtors. It turns out that it was not insolvency but liquidity problem for UK arm of Lehman Brother.
This is the confirmation of same view that most of the regulators and bankers have. Banks funded lot of its long term liabilities with short term funding instruments and this can not be continued in stressed period.
Lot of focus is already on liquidity even Basel committee has included liquidity rations in Basel 3 guide lines.
Question is who will get the windfall from this surplus ?


 

VaR implementations in banks

We have several text books those explains what is VaR and different approaches to calculate this. I have not come across something which describe how it actually implemented in banks.
There are several layers in which this whole methodology gets implemented in banks.
Each banks has CRO/ risk division and this division is responsible for calculating , reporting and maintaining risk numbers for the banks.

Crisis of 2008 has opened up lots of debate on risk management. Each bank has invested lot of money and investing in risk functions. Regulators have come down heavily on banks with tighter capital control and more regulations. I will write series of post that will explain how CRO/Risk division works in banks.