CLIENT
A top 3 US custodian bank
CHALLENGE
Short sale coverage and the need for low-cost avenues to increase securities inventory for many broker-dealers has created a robust market for securities lending. Custodians with large portfolios of securities often indemnify their customers from loss and earn a split fee for lending those securities to other financial institutions, a low risk and high margin business. However, indemnified securities lending creates extremely large due from balances in the banking book, representing the risk of financial counterparties failing to return the borrowed assets. In practice, pledged collateral normally eclipses the value of securities lent and is re-margined daily, greatly reducing or negating the tangible exposure to the custodian.
A challenge lies in quantifying the economic reality of this risk in a manner that considers the potential down-side price movements of both sides of the transaction: the security lent and the collateral received. Moreover, one must implement the calculation such that it reflects the true risks of this business for internal capital modeling: the ability to quickly liquidate collateral and replace securities lent in liquid markets.
The Federal Reserve issued a guidance letter under the Basel I capital rules permitting capital relief for certain securities lending portfolios: double indemnified transactions (re-hypothecation), and those secured by non-cash collateral. Capital could be reduced to a net exposure (securities lent – collateral received) plus Value at Risk (VaR), accurate to 99% confidence, using a market risk methodology to approximate an equivalent unsecured loan balance. The VaR must represent a stressed 5-day simulation of downside price movements against both the short and long positions by security type. Although reported quarterly, the calculation must execute daily for all reportable portfolios and prove reliable to a 97% confidence interval. Without adherence to this guidance letter, custodians are relegated to regulatory capital at 1.8% of aggregate gross nominal balance, punitive and potentially prohibitive for business line viability.
Any solution must also adapt to changing requirements for subsequent capital regimes (Basel II, etc.). Specifically, Basel II permits VaR treatment for a much broader range of repo-style portfolios, significantly expanding the opportunity for capital relief. In addition, it specifies criteria for collateral eligibility, including exclusion of sub investment grade and unrated debt, not present under Basel I.
On the technical side, we faced client-specific challenges from internal systems, which affected the ability to meet the Fed’s reliability benchmark. Some upstream systems compiled data manually, without systematic logic and validity checks, and many failed to meet service level agreements for timeliness of data delivery.
IDEAS
We developed ideas in three areas to help our client address the complex challenges of risk analysis and capital computation in securities lending:
Data Environment
Build a database environment that can model all data from the bank’s securities lending businesses, and use it to create portfolios of securities defined by counterparty collateral agreements. Model these agreements discretely within this data framework for ease of validation.
Run stressed VaR calculations, using historical securities prices as model factors, against both the securities lent and collateral components of the portfolio, and model risk based on the residual exposure plus VaR, as permitted under the Federal Reserve guidance letter. Use the central environment for data capture and definition to coordinate all calculations.
Reliability
To address the requirement of 97% reliability, and combat source system issues with data quality and timeliness, build a parallel processing architecture that allows for re-processing of dirty data or delinquent extracts delivered outside of a normal processing window. Allow the iterative data to flow through normal processing, delineated by a time dimension, facilitating analysis of sequential improvement in data quality and adherence to service level agreements. The most recent time stamp would alert users to the cleanest, most comprehensive data iteration.
Adaptability
Leverage the architecture established for the subset of securities lending portfolios calculated under Basel I, and expand it to include all of the repo-style portfolios eligible under Basel II. Tag each portfolio as applicable to a specific capital regime: Basel I, Basel II, economic capital, etc.
Include stream-based processing during the portfolio creation process. For instance, if the data is intended for Basel II reporting, include a filter to exclude non-compliant collateral. If relevant for Basel I, exclude the filter, potentially allowing the same set of data to be treated differently according to the intended reporting audience, easing data classification and ensuring accurate VaR calculations.
SOLUTION
The solution that we helped engineer created a central repository of securities lending data across lines of business and source systems, enabling comprehensive downstream processing. Out of this environment grew:
- A process to catalogue the details of counterparty collateral agreements.
- A process to construct portfolios of exposure and collateral based on these agreements.
- A stressed VaR calculation over a five day window of both exposure and collateral components, meeting the regulatory requirements for capital reduction.
In addition, we were instrumental in delivering a solution to comply with data reliability requirements. When unreliable source data became a critical inhibitor, eBIS stepped forward to address the problem with a proposal for an alternative processing path. We translated our ideas into a robust architecture for data re-processing that satisfied the regulatory reliability benchmarks. And we did so within a compressed timeframe, juggling resources and other project initiatives to ensure successful solution delivery.
RESULTS
Over $1 billion in regulatory capital savings. Regulatory capital reduction under Basel I from $1.41 billion to $6.8 million upon disclosure of VaR results in September 2007, with similar results ongoing. The liberated capital is available to the custodian for stock buy-backs, retirement of debt, and acquisitions, all of which contribute to shareholder value.
The solution provides a sensible, risk-sensitive capital calculation and reporting vehicle for an otherwise low risk, profitable line of business.