We will look at XVA further in Chapter 16.
Greater Levels of Capital
During the GFC it became very evident that banks were not maintaining enough capital to absorb trading losses caused by the significant fluctuations in financial markets and the credit events of companies such as Lehman Brothers. This capital deficiency resulted in many banks having to seek support from their governments to prevent their collapse.
Governments across the world were very aware of their need to protect the savings of investors and prevent the crisis from damaging real businesses (i.e., companies outside of financial services, such as manufacturers, retail, etc.) which require loans from banks to fund their working capital and investments. Consequently, the reaction from governments was significant. For example, in the United States the government passed legislation, the Emergency Economic Stabilization Act 2008, to support the purchase of up to $700 billion of troubled assets from banks (TARP). In Australia, the banks benefited from the government's guarantee on deposits and wholesale funding requirements for Australian deposit-taking institutions. Governments across Europe also effected similar measures.
As a result of this shock, the Bank for International Settlements (BIS) commenced with the design of Basel III, which sought to address the shortcomings in capital requirements that occurred during the GFC. If we fast-forward to today, we can observe that through Basel III, the Fundamental Review of the Trading Book (FRTB) and independent regulatory intervention, the levels of capital that banks now (and will) hold are higher than prior to the GFC. This has forced banks to be more deliberate about the size and quality of their assets, credit risk and the size and complexity of their market risk.
The businesses Product Control support are now being evaluated not only on their accounting P&L, but also on their P&L performance after considering capital costs. There are various measurements used in the industry to assess capital adjusted returns, one measure is economic P&L. Economic P&L takes a business's net operating profit after tax (NPAT) and deducts a cost of capital.
Economic P&L = NPAT − (capital employed × cost of capital)
NPAT is the P&L product control report to the desk after being adjusted for tax and non-trading costs. The cost of capital is the cost of maintaining the necessary levels of debt and equity that comprise the capital base.
For example, if a bank has issued $1 billion of ordinary shares, the cost of this capital is the return shareholders require on their equity investment in the bank (i.e., dividends and capital growth). That return is market driven and may be a per annum amount of 10 %, 12 %, 15 % and so on. For example, the rates desk used $200 million of capital to invest in sales and trading activities, which generated an NPAT of $80 million for the year. If the cost of capital is deemed to be 10 %, the economic P&L for the year would be:
As capital levels generally rise with increased risk, if a business increases risk, such as taking on more risk weighted assets, it will place downward pressure on economic P&L (as depicted in Figure 2.3).
Figure 2.3 The impact of increased capital
This focus on capital has led to product control spending more time reviewing the balance sheet, identifying and explaining significant changes in risk-weighted assets (RWA) and partnering with the business to help reduce unwanted increases in the balance sheet.
Greater Focus on Liquidity
Like any company, a bank needs a certain level of cash to operate, but during the GFC, the financial markets experienced prolonged periods of illiquidity. During this time, Northern Rock, a British bank, could not continue operating as their interbank counterparts ceased providing loans, and retail depositors withdrew their money in vast sums. This is known as a run on the bank. As a result of this illiquidity, the banks, regulators and the BIS started to place greater emphasis on a bank's liquid assets and their funding profile. In Basel III, the BIS introduced two requirements:
1. Liquidity Coverage Ratio (LCR)
“The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. The LCR will improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.”4
2. Net Stable Funding Ratio (NSFR)
The objective of the NSFR is to “promote resilience over a long time horizon by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis. The NSFR…supplements the LCR and has a time horizon of one year. It has been developed to provide a sustainable maturity structure of assets and liabilities.”5
The function responsible for maintaining the appropriate levels of liquidity is treasury. To influence better funding behaviour by the trading desks, treasury started to penalize trading desks who were funding themselves ineffectively; for example, buying a 2-year corporate bond and funding that purchase using an overnight loan from treasury, which is known as a tenor mismatch. Conversely, the trading desk could be rewarded if they were overfunding their assets, as this excess term funding could be used to provide funding to other business. For example, borrowing $100 million for two years to fund the purchase of $90 million two-year government bonds.
As product control reports the financial impact of these penalties and rewards in the P&L, the business relied on product control to identify which positions (assets and liabilities) were driving these P&L entries. For product control to assist the business they needed to understand the business' balance sheet, specifically the size and tenor of the asset and liabilities, and how treasury viewed this construction from their funding paradigm.
CHAPTER 3
Key Stakeholders
In the performance of their role, product control interact with numerous functions, each of which vary regarding their importance and frequency with which they interact. This chapter will introduce you to those functions which product control most commonly interact with.
Figure 3.1 illustrates the typical levels of interaction Product Control will have with each function.
Figure 3.1 Stakeholder interaction with product control
Front Office: Sales and Trading Desk
The front office staff have three main objectives:
1. Provide the bank's clients with a suite of products to meet their investment and risk management needs.
2. Risk manage the bank's market and credit risk exposures to safeguard the bank from adverse market movements.
3. Participate in risk-taking (proprietary trading) to generate profits for the bank.
The front office are the most significant stakeholder who product control interact with. In most banks they are considered a client of product control whilst also being a function that product control must monitor and control. There is also a high level of interdependency between the two functions as the front office have a large vested interest in ensuring the P&L accurately