Optimising this cat’s cradle of ratios is hugely significant for banks, as it directly affects the bottom line and their standing with the regulators.
Cross the hurdles of collateral optimisation
Negative interest rates, spread compression and year-end reporting deadlines are making banks look closely at balance sheet, liquidity and collateral optimisation.
The Liquidity Coverage Ratio (LCR) is already forcing banks to focus on short-term assets, and the introduction of the Net Stable Funding Ratio (NSFR) in 2021 will add an extra dimension to their ratio management.
The techniques and strategies that have emerged for optimisation have been sufficient for the short end of a bank’s funding. But market participants believe that these will be insufficient to meet the needs of the medium to long end, when NSFR comes in. In particular, many market participants believe it will be a game changer in terms of one-year stress horizons, which it treats very differently than the LCR.
At root, both ratios are looking for the same thing. Namely, can banks meet their obligations in times of stress. But the crucial difference is that the LCR looks to see if banks’ balance sheets are liquid enough to support a thirty-day period of stress. The NSFR assesses whether banks can fund themselves in the markets over a much longer time frame. In this regard it relies more on accountancy techniques than the traditional treasury focus on cash flow.
It would be wrong to say that NSFR and LCR are pulling banks in opposite directions, but they do have different requirements. The effects of this are hard to predict but two outcomes are certain. Given the importance of these ratios, banks will need to optimise, and this optimisation will have a real impact in the markets.
To some extent, this is also being driven by the explosion of negative interest rates in the wholesale markets. “The best rates that banks can get in Europe is now the ECB overnight deposit rate at minus 50bps,” says Corentine Poilvet-Clediere, Head of RepoClear and Collateral and Liquidity Management at LCH. “This overall environment means banks have an increased focus on collateral optimisation, and their partners have to be ever more dynamic in broadening the scope of eligible securities and offering a wider variety of solutions to post collateral such as pledge and triparty.”
The September 2019 spike in US repo rates also foreshadowed these outcomes. The normally stable market saw rates spike from the usual 2% level up to 10% as banks’ demand for short-term liquidity rose ahead of Q3 reporting deadlines. This was compounded by the high bank concentration levels in the US, their ongoing need to use less capital and the heightened demand for HQLA for collateral.
According to some market practitioners, the keys to unlocking the puzzle of optimisation lie in improving collateral management while at the same time increasing levels of automation. As spreads compress there is a structural need for more collateral in the market. Many market observers believe that banks need to structurally change by centralising their collateral management to give better visibility on the whole collateral stack, as well as expanding the use of existing assets.
Different markets have different characteristics, which means that even with a central collateral stack, local differences must be taken into account. Between the US and Europe for instance, these differences call for differing collateral strategies. “The European repo market is estimated to be around 50% cleared and the main driver of this has been the need to get balance sheet netting,” says Corentine Poilvet-Clediere.
Another popular trading strategy is reverse repos for cash balances. where companies come to the market to get a zero-return trade. This offsets initial margin and haircuts and is efficient for risk-weighted assets. It is, however, a European phenomenon and not yet commonly seen in the US.
Pension funds are also pushing increased demand for sponsorship and Total Return Swaps (TRS), which work well for equities and government bonds. The main problem with TRS, however, is that they are manually intensive and they need more automation to grow into a staple of the funding stack. If it can be automated, especially in the form of a triparty solution, then it will be highly applicable for banks to meet their funding ratios.
For automation to really bear fruit, there will need to be not only a proliferation of collateral platforms, but these will also need to be interoperable and easily onboarded onto bank’s platforms.
Banks looking to optimise their use of collateral therefore face a number of hurdles and it is clear that one size will not fit all, with banks in different markets having different requirements and access to different strategies. But the twin drivers of both balance sheet and liquidity ensure that collateral optimisation will remain at the forefront of their strategic thinking.