Risk management for Whales

Risk management for Whales


LVAR could help kill liquidity risk

Orderly liquidation of bankcrupt Banks

FED is proposing new measures  to prevent the chaotic crash of banks and  orderly liquidation of financial institution can be done.

RBI released consultative document for the uncleared margin requirement

The Reserve Bank of India released a discussion paper on margining un-cleared OTC business, in the same framework as others. The RBI intend to mandate the schedule based approach to IM, unless they give approval for a VaR based approach. 

Will there be any benefit for Banks to create highly expensive infrastructure for IMM models

BCBS has recently released consultative document, Reducing variation in credit risk-weighted assets – constraints on the use of internal model approaches. It proposed that banks be barred from using internal models when they calculate how risky certain assets are. Lending to other financial institutions and large companies, and holding equities are the areas most affected.

The proposed changes to the IRB approaches set out in this consultative document include a number of complementary measures that aim to:
1.  Reduce the complexity of the regulatory framework and improve comparability
2. Address excessive variability in the capital requirements for credit risk.

Specifically, the Basel Committee proposes to:

• Remove the option to use the IRB approaches for certain exposures, where it is judged that the model parameters cannot be estimated sufficiently reliably for regulatory capital purposes 
• Adopt exposure-level, model-parameter floors to ensure a minimum level of conservatism for portfolios where the IRB approaches remain available 
• Provide greater specification of parameter estimation practices to reduce variability in risk weighted assets (RWA) for portfolios where the IRB approaches remain available.

Under the proposal, banks will have to use a standardised method of calculating the riskiness of loans to financial institutions and to large corporates with assets of more than €50bn. The Basel group believes there is so much publicly available information on the credit risk of such institutions, that banks are rarely able to provide a better estimate than an approach standardised by regulators.

These proposed regulation are already dubbed as BASEL IV by street. Banks have already spent billions of dollars to comply with the plethora of regulatory changes after the 2008 financial crisis.
Argument is if banks will not be able to use the IMM models for most of the derivative portfolio, as most of the derivative trades happens among financial firms, then how much benefit will banks have in developing highly complex IMM models.

Swiss regulators pushed for 5% leverage ratio for TBTF banks

• As per Bloomberg, Swiss regulators will require that country's biggest banks to have capital of 5% of total assets - this will be in line with the rule for U.S. too-big-to-fail lenders, and significantly above the 3% minimum set by Basel.

• UBS and Credit Suisse have argued the Swiss financial system isn't comparable to the U.S. with its far deeper capital markets.

• Leverage ratios have gained favor among regulators as the most effective way to evaluate a bank’s robustness because the method doesn’t involve estimates of risks on their activities.

• Switzerland imposed some the world’s strictest too-big-to-fail requirements in 2011 after the government came to UBS’s rescue during the 2008 financial crisis. UBS and Credit Suisse have assets of 1.83 trillion francs combined, about three times the size of the Swiss gross domestic product, making the two banking behemoths a disproportionately bigger danger to their country’s economy if they fail than their peers elsewhere. Both are compliant with all Swiss capital rules.

Libor Reforms

ICE Benchmark Administration (IBA), the new administrator of Libor has published a position paper on the future evolution of Libor. Following major reforms were proposed by the FSB on July 2014 for the major interest rate benchmark.

• Strengthening the existing IBORs and other potential reference rates based on unsecured bank funding costs by underpinning them to the greatest extent possible with transactions data (“IBOR+”)  
• Developing alternative, nearly risk-free reference rates (RFR) since FSB Members believe that certain financial transactions, including many derivatives transactions, are better suited to reference rates that are closer to risk-free.

Another concern was raised that reference rate should be based exclusively in actual transactions. But this can be applicable only  for the currencies or markets that have enough liquidity and actual transactions. When conditions in the local market do not allow pure transaction rates (ones derived mechanically from transacted data without use of expert judgement), authorities should work with and guide the private sector to promote rates which are derived on a waterfall of different data types: underlying market transactions first, then transactions in related markets, then committed quotes, and then indicative quotes.

IBA has proposed many reforms and it is expects the market participant's view by Dec 2014.Focus is on making the whole process including Libor definition , calculation methodologies used by individual banks, submitting Libor rates and selecting the final Libor rates, more objective and completely transparent.

I agree with Prof Jayanth that submitter should not do the interpolation for the missing points in the Libor calculation as this can be more efficiently done by the administrator.

Another important proposed change is to change the trimming of the top and bottom quartiles allows for the exclusion of outliers from the final calculation. This trimming methodology was benefited to counter manipulations. From this perspective, ‘topping and tailing’ may be less relevant in that it would adjust a rate that had already been calculated formulaically from observable and testable evidence. As mentioned in the position paper currently several alternatives of this approach are being evaluated. If this smoothing of submitted Libor rates gets hanged than it can have large impact on rate and on it's volatility.

Battle lines are drawn, among CCPs, who will win rates

A good read on this.

ISDA survey: OTC derivative are important but fragmentation is concern

ISDA conducted end user survey to get more insight into the derivative uses by end users.Biggest highlight is OTC derivatives are not going away and almost eighty seven percent of respondents thinks that OTC derivative are very important or important. Almost eighty percent of respondents thinks that either their uses of OTC derivative are going to be same or will increase in future. Important to know that for what purpose end users uses the OTC derivatives.

1. Sixty five percent of respondents uses OTC derivatives for managing exposures (to currencies, commodities, credit, etc.) so that firm can maintain and improve pricing, operating expenses and returns. 
2. Forty seven  percent of respondents use these for reducing financing costs and managing the cost of capital that  firm borrows to invest in our business
3. Forty five percent of respondents use these derivatives for hedging exposures in international markets to maintain and enhance their competitiveness.
4. Thirty percent of respondents uses derivatives to hedging risks of new activities and investments so my firm can effectively invest for growth

It is clear that firms uses derivatives to manage or reduce uncertainty and these derivatives are getting used as important risk management tool. “It is clear that end-users around the globe see OTC derivatives as vital risk management tools and expect to continue using them to hedge their risk,” said Scott O’Malia, ISDA Chief Executive Officer. “End-users realize the benefits of the regulatory reforms that are currently being put in place, but they’re worried about the effects of market fragmentation on liquidity and cost.”

The survey also highlights that the top three concerns for end-users regarding their ability to use derivatives include: increased costs of hedging (60%), the scope of cross-border derivatives regulations (44%) and uncertainty about regulations in their firm’s principal business regions (38%).
Total 125 firms responding to the survey, 28% were non-financial corporates and 55% were financial institutions.

What is remote booking and why banks are now going away from it

When trader hired by one legal entity is taking positions or managing risk in different legal entity  registered in different jurisdiction, this practice is called remote booking. It is trader hired by Singapore legal entity is booking trades in UK entity and both legal entities are under umbrella of one big investment bank.

Investment banks typically book most of their Asian trading in their London subsidiaries,which offers several benefits relating to capital efficiency, staffing and operations. 

Under the UK’s capital rules, banks are able to achieve significant savings through hedging and netting, identifying and cancelling out trades that offset one another, such as a short and a long position in the same stock. This process, which is more effective when a large number of trades are held in the same place, reduces the overall risk profile of the book and therefore the capital that must be held against it.

Typically, US banks book all non-US trades in London, while European banks book all European and Asian trades there. Some Asian banks, including Japan’s Nomura, also have big London booking centres. By funnelling trade flow back to London, global banks have also been able to minimise the amount of capital they have had to allocate to their Asian legal entities. Keith Pogson, managing partner, Asia Pacific financial services, at Ernst & Young in Hong Kong, said: “In Asia, many international banks have historically made vehicles capital-light – as they act as agents.”

Regulators are now not happy with this practice as they can't effectively control someone sitting in other jurisdiction and taking risk in entities registered in their jurisdiction. It becomes more important when portfolio size of these foreign banks are comparable to local investment banks.
The most immediate regulatory pressure, however, is from the UK’s Financial Conduct Authority, which is growing increasingly concerned by the volume of foreign-originated trades held in its jurisdiction. UK regulators have asked foreign banks to setup UK CRO if not already. 

Several banks are believed to be building new booking hubs in Asia which is understood to be undertaking a huge project to restructure its legal entities and booking hubs. These projects, which would involve legally transferring trades booked in London to new Asian entities, are hugely complex and the banks are understood to be doing intensive scenario analysis. It depends on lot of factors such as for which products you have licence to trade in that region, what are the region's guide line for calculating and reporting risk. 

With these developments booking practice is changing from hub to local.

Explaining the basis: Cash Vs Default swap

I was trying to figure out all different factors for the difference between CDS and bond basis. I got Lehman Brothers research paper on this. In the paper the aim is to explore the differences between the cash and default swap markets for a given credit and develop a frame-work for looking at these differences. Ultimately, the goal is to enable the reader to identify and understand the many reasons for the divergence between the two markets and to give the reader the tools to evaluate it.
Broadly reasons for this spread can be divided into Fundamental factors and Market driven factors.  Fundamental factors are fundamental difference between the CDS and it's replication using the Bond and asset swap spread products. 
Market factors refers to the nature of the market in which the cash and defaults swaps gets traded and so include the demand , supply and liquidity.

The Changing Landscape for Derivatives

OTC derivative market has changed and continue changing after the 2008 banking crisis. Big banks are facing heat from regulators and they are forcing banks to standardize the OTC derivatives. A good read on this , The Changing Landscape for Derivatives.