Structural risk management

An initial model for trading risk

Structural risk management

The recent financial crisis highlighted the importance of a robust liquidity and funding risk framework. International organizations such as the Basel Committee on Banking Supervision and the Institute of International Finance recommend the inclusion of liquidity costs and benefits in product pricing.

An appropriate funding and transfer pricing framework will be the basis for senior management’s decisions to identify value-enhancing business, to measure performance across profit centers and to compensate for performance-based remuneration.

Liquidity risk can easily be included in transfer prices in retail banking, for example by applying the cash flow-matched funding rate and the product-specific funding spread curve.

Establishing a funding model

However for trading desks, liquidity risk measurement and transfer prices are more complex. With this in mind, the following funding model could be a starting point: imagine a trading desk that buys and sells bonds. How, and for what price, could the desk’s activities be funded independently from the banks’ actual funding sources and strategy? Based on the trader’s time horizon, one would assume cheap short-term funding.

But in a liquidity squeeze such as during the financial crisis in 2008 and 2009, rolling the funding over might be very expensive or even impossible, putting the bank’s continuation at risk. Longer funding duration mix would decrease this liquidity risk along with higher costs and an interest rate risk mismatch (which can be solved e.g. by interest rate swaps).

Funding model

Such a mix could be derived from the security’s eligibility for repurchase transactions.

Haircuts as an indicator of eligibility

The level of eligibility is indicated by so called ‘haircuts’. The haircut represents the discount on the market value of a security which cannot be used as collateral. Generally, better credit quality and lower market and liquidity risk of the security results in a lower haircut. For funding and transfer pricing, the market value of the security after haircut could be funded short-term by repo transactions. In contrast, the haircut portion represents the amount that needs to be funded longer term.

If a product is illiquid and is not accepted as collateral, then the haircut is 100%, resulting in a pure medium- and long-term funding assumption, triggering higher costs charged to the trading desk. The diagram below illustrates this.

A feasible funding structure for the trading desk

This model must be viewed as a part of the entire liquidity management framework. It suggests a feasible funding structure according to general funding duration (short vs. long term) and type of funding (encumbered vs. unencumbered) for the trading desk. However, the funding structure needs additional specification, for instance with respect to the actual average funding duration and the currency mixture.

As a next step, the model could be used as a basis for transfer pricing, i.e. which (interest and liquidity) costs are charged to the trading desk. The approach would set reasonable incentives since less liquid or illiquid assets would consume higher funding costs requiring higher returns to make the business profitable. At the same time, it builds the basis for performance based remuneration. Finally, the model would ensure that funding is less of an issue in a liquidity crisis situation.