In this final instalment of the three part article series focusing on capital and credit management, we explore how the securities finance industry is coping with the changes in regulation and the operating models they are having to implement.
In the wake of the 2008/2009 financial crisis, the Basel Committee on Banking Supervision (BCBS) introduced a range of capital adequacy and liquidity requirements, better known as Basel III standards. Critical measures introduced included, risk based capital adequacy (RWA), liquidity coverage ratio (LCR), net stable funding ratio (NSFR) and leverage ratio.
The introduction and on-going implementation of the Basel III standards is having far reaching effects in many areas including securities finance and prime brokerage. The full impact of these requirements has yet to be fully felt. What is clear is that as securities finance transactions are often low risk, the margins are typically relatively thin. This means that any changes that negatively impact costs, regulatory or otherwise, are going to adversely impact the viability of a trade.
In order for a business to manage Basel III generated capital and liquidity charges, it cannot view these as a homogenous cost across the business line (e.g. securities finance) or even broader product hierarchies (e.g. Equity Markets). The various Basel III elements will generate varying costs on the business depending on the client, the asset type, the strategy type and the business capital structure. Firms must also take into account that they will have assessed asset quality (HQLA) which will differ to their competitors. So not only do they have internal costs to take into account but also how these could affect the ability to transact at a competitive level. As a consequence, desks may be tempted to go to the street for funding rather than approach the internal treasury.
The complexities of securities financing mean it is critical to have the transparency of costs and revenue at the client, asset and strategy level. Putting all this together is the challenge as they try to understand funding costs and make informed decisions. It is also clear from working with many of our clients that “one size doesn’t fit all”. Take JGBs as an example, one of the measures used to help determine the HQLA level is the depth of the repo market. Some of our clients allocate level 1 whilst others have assigned level 2. In another example; a loan in one business may improve inflows for liquidity coverage but in another business it may worsen it.
In all cases, firms now need sophisticated tools to perform the analysis. These tools are then scrutinised in annual regulatory reviews. Some key outcomes of performing funding analysis include:
- Ability to manage the funding cost for the liquidity and stable funding requirement for each desk, client, trade and stock loan demand
- Manage the selection of inventory for potential hypothecation obtained from the margin lending business to improve the starting position of the stock loan desk
- Compare the value of different sources of funding
- Understand the availability of liquidity coverage or stable funding as a potential business asset
In summary, the impact of Basel III on the securities finance business means market participants need to be able to understand the cost of funding, how best to optimise the use of inventory and the impact of transactions on the balance sheet. While some firms are already able to perform funding analysis, many are still wrestling with the challenge. It is a complex task to gather data from multiple sources, put this into a consistent format, apply the right rules and deliver meaningful reports back.
Part 2: Capital And Credit Management: Broker-Dealers Coping With The Pace And Change Of Regulation: Thought Piece From Andrew Powell, Chief Operating Officer, Softek
