Sunday, June 22, 2014
Lender of last resorts & dealers of last resorts
Be the "Lender of last resorts" in crisis period is a classical advise given by the Walter Bagehot to central banks. Walter mentioned, in 1873, that in time of crisis central banks must lend freely but at high rate.
But as Bagehot pointed out, by lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central bank can try to distinguish insolvent banks from illiquid ones; and by charging a penalty rate of interest, it ensures that it is truly the lender of last resort.
But as Bagehot pointed out, by lending liberally, central banks make it less likely that their money will be needed. By demanding good collateral, the central bank can try to distinguish insolvent banks from illiquid ones; and by charging a penalty rate of interest, it ensures that it is truly the lender of last resort.
But in sub prime crisis Fed had to be not only the lender of last resort but also "Dealer of last resort" and later it acted as private capital market.
Below is the snap shot of how balance sheet of Fed changed during the crisis time. Size of balance sheet increased from almost 1 trillion to 2.5 trillion between Jul 2008 to Jan 2010.
Fed responded to crisis initially with selling off treasury securities and lent out the proceeds through various extended discount facility. After the collapse of Lehman and AIG, money market was almost frozen both domestically and internationally. Banks were not willing to lend each other. Repo collateral haircuts reached to record high and even banks were not accepting the mortgage securities as collateral. In this scenario Fed did even more and shifted much of the wholesale money market onto its own balance sheet. This is referred as Dealer of last resort.
Once emergency situation was over than Fed replace the temporary loans of various financial sector with permanent ones like mortgage securities.
Below is the snap shot of how balance sheet of Fed changed during the crisis time. Size of balance sheet increased from almost 1 trillion to 2.5 trillion between Jul 2008 to Jan 2010.
Fed responded to crisis initially with selling off treasury securities and lent out the proceeds through various extended discount facility. After the collapse of Lehman and AIG, money market was almost frozen both domestically and internationally. Banks were not willing to lend each other. Repo collateral haircuts reached to record high and even banks were not accepting the mortgage securities as collateral. In this scenario Fed did even more and shifted much of the wholesale money market onto its own balance sheet. This is referred as Dealer of last resort.
Once emergency situation was over than Fed replace the temporary loans of various financial sector with permanent ones like mortgage securities.
Saturday, June 21, 2014
OTC Derivatives Valuation: Adoption of Multiple Pricing Curve
Good read on OTC derivative valuation and how it changed after the 2008 crisis.
OTC Derivative Valuations
OTC Derivative Valuations
Monday, June 16, 2014
Credit Default swap - IV , Risky PV01
Let's discuss how MTM of CDS gets calculated. CDS are traded products and booked into trading books, except some exceptions, so these products needs to be marked to fair value daily.
At the inception of CDS, both leg of CDS have equal value but this get change as premium level moves for reference entity. These changes in premium reflects changes in credit quality of reference entity and general market dynamics.These changes in premium cause CDS to have either a positive or negative net present value. For a protection buyer, if the market premium moves wider than the contract premium, he will experience a MTM gain because he bought the protection cheaper than currently available in the market. Vice versa if market premiums tighten. Obviously the protection seller experiences the opposite MTM results.
Calculating a CDS MTM is the same as calculating the cost of entering into an offsetting transaction. Suppose an investor bought 5-year protection at 100bp per annum, and 1 year later the protection widened to 120bp. The investor would then have a MTM gain. To calculate this MTM amount, we can assume a hypothetical offsetting trade where the investor sells protection at 120bp for 4 years, thereby hedging his position. Assume also that the offsetting trade matches the original one perfectly in terms of contract terms, including the same payment and maturity dates, except for the contract premium. This will leave a residual cash flow of 20bp per annum (5bp per quarter) for 4 years in favour of the investor, effectively a 4-year annuity. The present value of this annuity is the MTM amount.
At the inception of CDS, both leg of CDS have equal value but this get change as premium level moves for reference entity. These changes in premium reflects changes in credit quality of reference entity and general market dynamics.These changes in premium cause CDS to have either a positive or negative net present value. For a protection buyer, if the market premium moves wider than the contract premium, he will experience a MTM gain because he bought the protection cheaper than currently available in the market. Vice versa if market premiums tighten. Obviously the protection seller experiences the opposite MTM results.
Calculating a CDS MTM is the same as calculating the cost of entering into an offsetting transaction. Suppose an investor bought 5-year protection at 100bp per annum, and 1 year later the protection widened to 120bp. The investor would then have a MTM gain. To calculate this MTM amount, we can assume a hypothetical offsetting trade where the investor sells protection at 120bp for 4 years, thereby hedging his position. Assume also that the offsetting trade matches the original one perfectly in terms of contract terms, including the same payment and maturity dates, except for the contract premium. This will leave a residual cash flow of 20bp per annum (5bp per quarter) for 4 years in favour of the investor, effectively a 4-year annuity. The present value of this annuity is the MTM amount.
However, we need to bear in mind that these cash flows can cease, since the investor will
receive the 5bp per quarter only until the earlier of a credit event and contract maturity. Upon
the occurrence of a credit event, Credit Event Notices will be served and premium payments will then cease on both transactions, wiping out future annuity payments.
Valuing this annuity payment therefore involves more than just discounting it using risk
free rates. It also involves weighting the annuity with the probabilities of receiving these
quarterly payments, i.e., the probabilities of no credit events occurring before each quarterly payment date. These are the survival probabilities that were introduced in the previous chapter. So, the MTM of a CDS is the present value of an annuity representing the difference between the contract premium and the current market premium, with the annuity cash
flows weighted by the survival probabilities.
MTM = (change in spreads)*(number of periods)*(survival probability)*(discount factor)
Risky PV01- Risky PV01 being the sum of the discount factors weighted by their corresponding survival probabilities, i.e., the sum of the risky discount factors. This risky
PV01 measures the present value of 1bp risky annuity received or paid until the earlier
of a credit event or the maturity of the CDS. The CDS MTM is therefore the annuity multiplied by the PV01.
MTM = Annuity * Risky PV01
Wednesday, June 11, 2014
Negative deposit rates..
We live in the central bank's era. The current domination of central banks is unprecedented. Earlier they managed the same responsibility , price and finance stability, with limited tools such as twisting short term borrowing and lending rate but now central banks have evolved a lot and they have tried lot of other tools to manage the same responsibility and still results are not coming the way these should have been.
ECB has cut the deposit rates to -0.10 per cent and now deposit rates are Negative.
We are not sure whether this will work and push the banks to lend money to house holds or business. Banks that were reluctant to lend when rate was almost zero will not find any reason now to lend more with negative deposit rate. They can store cash in their vaults rather than depositing it with ECB or they can pass this cost to customer.It is global capital market and now with negative deposit rate investors or euro zone banks can flee outside to earn the better yields.
The real purpose of this rate cut could be not about bank lending at all. I think it is about German disinflation and the exchange value of the Euro, Currency War.German CPI inflation is currently 0.9%, far below the ECB’s target of “close to” 2%, and trending downwards. It’s unclear exactly why this is, but one possibility is the strong Euro. Because of Germany’s export dependence, a strong Euro puts downwards pressure on German inflation – indeed this is why historically the Bundesbank, ever the inflation hawk, has preferred a strong currency. As Germany is very dominant in the Eurozone, German disinflation feeds through into low Eurozone inflation.
Tuesday, June 10, 2014
Indian Public sector banks
Top five public sector banks of India make up more than 70 per sent market share of Indian banking. These banks have very high NPAs and are being managed very poorly. There are several issues with these public sector banks. We could start with their rising bad loans. Total stressed assets, a figure that combines both non-performing and restructured loans, jumped to almost 11 per cent of lending in March.
Leverage ?, In 2012-13 the average leverage ratio (defined as the ratio of total assets of a bank to its equity capital) was about 16.5 per cent for public sector banks as against about 10 per cent for private sector banks.
Capital? Quite a few public sector banks fail their requirements and some more just scrape by, despite the regulatory “forbearance” which the RBI provides on restructured assets. Government needs to provide more than $28 bn as new capital for these state backed banks by 2018 and much more than this to make them Basel 3 compliant.
Latest report of P J Nayak committee on state backed banks have suggested lot of recommendation for restructuring these banks.
I believe other problem have grown with time because of poor management and forced political decision on these banks. These issues can be solved with time if we can achieve below two major reforms.
Public sector banks should get the equal treatment in compare to Indian private banks. Currently these are regulated by RBI and Finance Ministry. If these banks have to compete with private banks than they should have same yardstick.
Public sectors banks should be completely professionally managed and government should not be involved in any major decision such as appointing directors , chairman.This can be achieved by making a intermediary investment firm between government and these banks.
Some of the recommendation that related to above two points.
Recommendation 2.2: There are several external constraints imposed upon public sector banks which are inapplicable to their private sector competitors. These constraints encompass dual regulation (by the Finance Ministry, and by the RBI, which goes substantially beyond the
discharge of a principal shareholder function); the manner of appointment of directors to
boards; the short average tenures of Chairmen and Executive Directors; compensation
constraints; external vigilance enforcement; and applicability of the Right to Information Act.
Each of these constraints disadvantages these banks in their ability to compete with their
private sector competitors
Recommendation 4.2: The Government should set up a Bank Investment Company (BIC) to hold equity stakes in banks which are presently held by the Government. BIC should be incorporated under the Companies Act, necessitating the repeal of statutes under which these banks are constituted, and the transfer of powers from the Government to BIC through a suitable shareholder agreement and relevant memorandum and articles of association.
Recommendation 4.3: While the Bank Investment Company (BIC) would be constituted as a
core investment company under RBI registration and regulation, the character of its business
would make it resemble a passive sovereign wealth fund for the Government's banks. The
Government and BIC should sign a shareholder agreement which assures BIC of its autonomy
and sets its objective in terms of financial returns from the banks it controls. It is also vital that
the CEO of BIC is a professional banker or a private equity investment professional who has
substantial experience of working in financial environments where investment return is the
yardstick of performance, and who is appointed through a search process. While the non-
executive Chairman and CEO of BIC would be nominated by the Government, it is highly
desirable that all other directors be independent and bring in the requisite banking or
investment skills.
Recommendation 4.4: The CEO of the Bank Investment Company (BIC) would be tasked with
putting together the BIC staff team. BIC employees would be incentivised based on the financial returns that the banks deliver. If such incentivisation requires the Government to hold less than 50 per cent of equity in BIC, the Government should consider doing so, as it will be the prime financial beneficiary of BIC's success.
Recommendation 4.5: The Government should cease to issue any regulatory instructions
applicable only to public sector banks, as dual regulation is discriminatory. RBI should be the
sole regulator for banks, with regulations continuing to be uniformly applicable to all
commercial banks.
Leverage ?, In 2012-13 the average leverage ratio (defined as the ratio of total assets of a bank to its equity capital) was about 16.5 per cent for public sector banks as against about 10 per cent for private sector banks.
Capital? Quite a few public sector banks fail their requirements and some more just scrape by, despite the regulatory “forbearance” which the RBI provides on restructured assets. Government needs to provide more than $28 bn as new capital for these state backed banks by 2018 and much more than this to make them Basel 3 compliant.
Latest report of P J Nayak committee on state backed banks have suggested lot of recommendation for restructuring these banks.
I believe other problem have grown with time because of poor management and forced political decision on these banks. These issues can be solved with time if we can achieve below two major reforms.
Public sector banks should get the equal treatment in compare to Indian private banks. Currently these are regulated by RBI and Finance Ministry. If these banks have to compete with private banks than they should have same yardstick.
Public sectors banks should be completely professionally managed and government should not be involved in any major decision such as appointing directors , chairman.This can be achieved by making a intermediary investment firm between government and these banks.
Some of the recommendation that related to above two points.
Recommendation 2.2: There are several external constraints imposed upon public sector banks which are inapplicable to their private sector competitors. These constraints encompass dual regulation (by the Finance Ministry, and by the RBI, which goes substantially beyond the
discharge of a principal shareholder function); the manner of appointment of directors to
boards; the short average tenures of Chairmen and Executive Directors; compensation
constraints; external vigilance enforcement; and applicability of the Right to Information Act.
Each of these constraints disadvantages these banks in their ability to compete with their
private sector competitors
Recommendation 4.2: The Government should set up a Bank Investment Company (BIC) to hold equity stakes in banks which are presently held by the Government. BIC should be incorporated under the Companies Act, necessitating the repeal of statutes under which these banks are constituted, and the transfer of powers from the Government to BIC through a suitable shareholder agreement and relevant memorandum and articles of association.
Recommendation 4.3: While the Bank Investment Company (BIC) would be constituted as a
core investment company under RBI registration and regulation, the character of its business
would make it resemble a passive sovereign wealth fund for the Government's banks. The
Government and BIC should sign a shareholder agreement which assures BIC of its autonomy
and sets its objective in terms of financial returns from the banks it controls. It is also vital that
the CEO of BIC is a professional banker or a private equity investment professional who has
substantial experience of working in financial environments where investment return is the
yardstick of performance, and who is appointed through a search process. While the non-
executive Chairman and CEO of BIC would be nominated by the Government, it is highly
desirable that all other directors be independent and bring in the requisite banking or
investment skills.
Recommendation 4.4: The CEO of the Bank Investment Company (BIC) would be tasked with
putting together the BIC staff team. BIC employees would be incentivised based on the financial returns that the banks deliver. If such incentivisation requires the Government to hold less than 50 per cent of equity in BIC, the Government should consider doing so, as it will be the prime financial beneficiary of BIC's success.
Recommendation 4.5: The Government should cease to issue any regulatory instructions
applicable only to public sector banks, as dual regulation is discriminatory. RBI should be the
sole regulator for banks, with regulations continuing to be uniformly applicable to all
commercial banks.
Saturday, May 31, 2014
Global liquidity regulation , supervision and risk management
A good read on liquidity risk measures and latest BCBS guide lines for liquidity risk management.
Liquidity and VaR
Lot of focus has been shifted on liquidity risk management. Basel committee also planning to recommended that holding period of VaR calculation should be based on asset classes and time required to unwind the positions. It is understood that liquidity affects risk management because if markets are not liquid than it will take more time to unwind the positions. Interestingly risk management also affects the liquidity. Tighter risk management reduces liquidity, which in turn leads to tighter risk management, etc. This can help explain sudden drops in liquidity and, since liquidity is priced, in prices in connection with increased volatility or decreased risk-bearing capacity. This paper provides a model of the interaction between risk-management practices and market liquidity.
Sunday, May 18, 2014
Indian Money market instruments - Repo & Call
Repurchase Agreement (Repo) is an instrument for borrowing funds by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed.
The reverse of the repo transaction is called ‘reverse repo’ which is lending of funds against buying of securities with an agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.
RBI has permitted select entities (scheduled commercial banks excluding RRBs and LABs, PDs, all-India FIs, NBFCs, mutual funds, housing finance companies, insurance companies) to undertake repo in both the repo market.
The reverse of the repo transaction is called ‘reverse repo’ which is lending of funds against buying of securities with an agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.
It can be seen from the definition above that there are two legs to the same transaction in a repo/ reverse repo. The duration between the two legs is called the ‘repo period’. Predominantly, repos are undertaken on overnight basis. Settlement of repo transactions happens along with the outright trades in government securities. Repo that are not overnight termed as Term Repo.
Earlier repo securities in corporate debt allowed except CPs, CDs and NCDs maturing in less than one year. But from Jan 2013 RBI also permitted repo these securities. Only listed corporate debt securities that AA or above rated are eligible to be used for repo.
However volume in "Repo in corporate debt" is very less. This can be due to sharp haircut ,10% -12%-15%, while in CBLO haircuts are 5%. Also in "Repo in corporate debt" market pricing is not based on online platform but lender needs to find out the borrower while in CBLO market pricing is determined through online ask - bid spreads.
Call/Notice/Term Money -
The call/notice/term money market is a market for trading very short term liquid financial assets that are readily convertible into cash at low cost. The money market primarily facilitates lending and borrowing of funds between banks and entities like Primary Dealers. An institution which has surplus funds may lend them on an uncollateralized basis to an institution which is short of funds.
The period of lending may be for a period of 1 day which is known as call money and between 2 days and 14 days which is known as notice money. Term money refers to borrowing/lending of funds for a period exceeding 14 days. The interest rates on such funds depends on the surplus funds available with lenders and the demand for the same which remains volatile.
This market is governed by the Reserve Bank of India which issues guidelines for the various participants in the call/notice money market. The entities permitted to participate both as lender and borrower in the call/notice money market are Scheduled Commercial Banks (excluding RRBs), Co-operative Banks other than Land Development Banks and Primary Dealers.
Scheduled commercial banks are permitted to borrow to the extent of 125% of their capital funds in the call/notice money market, however their fortnightly average borrowing outstanding should not exceed more than 100% of their capital funds (Tier I and Tier II capital). At the same time SCBs can lend to the extent of 50% of their capital funds on any day, during a fortnight but average fortnightly outstanding lending should not exceed 25 per cent of their capital funds.
Co-operative Banks are permitted to borrow upto 2% of their aggregate deposits as end of March of the previous financial year in the call/notice money market.
Primary Dealers can borrow on average in a reporting fortnight up to 225% of the total net owned funds (NOF) as at end-March of the previous financial year and lend on average in a reporting fortnight up to 25% of their NOF.
The trades are conducted both on telephone as well as on the NDS Call system, which is an electronic screen based system set up by the RBI for negotiating money market deals between entities permitted to operate in the money market. The settlement of money market deals is by electronic funds transfer on the Real Time Gross Settlement (RTGS) system operated by the RBI. The repayment of the borrowed money also takes place through the RTGS system on the due date of repayment.
This market is governed by the Reserve Bank of India which issues guidelines for the various participants in the call/notice money market. The entities permitted to participate both as lender and borrower in the call/notice money market are Scheduled Commercial Banks (excluding RRBs), Co-operative Banks other than Land Development Banks and Primary Dealers.
Scheduled commercial banks are permitted to borrow to the extent of 125% of their capital funds in the call/notice money market, however their fortnightly average borrowing outstanding should not exceed more than 100% of their capital funds (Tier I and Tier II capital). At the same time SCBs can lend to the extent of 50% of their capital funds on any day, during a fortnight but average fortnightly outstanding lending should not exceed 25 per cent of their capital funds.
Co-operative Banks are permitted to borrow upto 2% of their aggregate deposits as end of March of the previous financial year in the call/notice money market.
Primary Dealers can borrow on average in a reporting fortnight up to 225% of the total net owned funds (NOF) as at end-March of the previous financial year and lend on average in a reporting fortnight up to 25% of their NOF.
The trades are conducted both on telephone as well as on the NDS Call system, which is an electronic screen based system set up by the RBI for negotiating money market deals between entities permitted to operate in the money market. The settlement of money market deals is by electronic funds transfer on the Real Time Gross Settlement (RTGS) system operated by the RBI. The repayment of the borrowed money also takes place through the RTGS system on the due date of repayment.
Arbitrage b/w CBLO and repo market
There can be arbitrage opportunity for market participants who have access of both the markets. If repo rate is less than CBLO rate than banks or PDs can borrow in repo market and lend that money in CBLO market for almost risk free return.
If CBLO rate is less than reverse repo rate than banks can borrow in CBLO market and park that money with RBI at reverse repo rate for risk free return.
So for no arbitrage CBLO rate should be in between of repo and reverse repo rate. Now reverse repo rate is always 100 basis point less than repo rate.
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