Why pending rate rises fuel the need for collateral optimisation

Giles Kenwright is head of regulatory advisory at Delta Capita

Eight years on from the global financial crisis, and banks continue to face a growing number of challenges.  Many have ceased or significantly reduced proprietary trading, with the resulting reduction in both risk and reward. This period has also seen lower risk appetite among many investors and continuing global competition which has put pressure on profit margins, writes Giles Kenwright

If this wasn’t enough, regulatory demands to tie up higher levels of capital have resulted in a reduction in working capital and smaller balance sheets.   Tighter regulatory requirements for collateral and the heightened need to protect against counterparty default, coupled with an over reliance on cash collateral, has further reduced profitability.

With these constraints, it is unlikely that we’ll see a return to the record profit margins generated before the term ‘subprime’ entered everyday language.

The Bank for International Settlements 2014/15 annual report recently stated “Globally, interest rates have been extraordinarily low for an exceptionally long time”.  But with the Fed now suggesting that US rates may rise before the year is out, we could soon see global economic interest rates starting to rise from their unprecedented lows – which will further increase pressure on banks’ profitability.

The cost of collateral

The 2015 ISDA Margin Survey indicated that cash still accounts for over 75% of the $5.01 trillion collateral supporting non-cleared derivative transactions, with USD and EUR comprising the bulk of this. A 1% rise in interest rates could therefore cost the industry more than $37.5 billion in increased funding costs on cash collateral alone. This figure could increase further if the predictions of a significant collateral shortage, once the move to central clearing has been completed, are to be believed.

Higher interest rates will also increase funding costs associated with the higher levels of regulatory capital now demanded by Basel III, as well as increasing the cost of financing the balance sheet.  The continued high reliance on cash collateral indicates that collateral management processes are still far from optimal.

Collateral optimisation

Due to the increasing costs, collateral optimisation is required to ensure banks deliver the least expensive assets to each counterparty while complying with regulatory constraints. These typically stipulate the need for high quality liquid assets and haircuts for most other collateral.

Banks should be reducing their reliance on cash as collateral and increasing the utilisation of government bonds and high-grade corporate securities.  Historically, collateral has been managed in silos, with each desk managing their own collateral pools.  In order to be more effective, banks must have a firm-wide holistic view of collateral in near-real time.

With access to timely and precise information, coupled with the appropriate analysis tools, banks can perform a pre-trade optimisation assessment to give traders an accurate view of stock availability and the cost of the collateral associated with a trade.  Delivering collateral effectively can therefore have a profound impact on the trading desks’ efficiency.

For many banks however, the data on collateral and collateral management applications are fragmented across geographic and business lines.  The first step in optimising collateral management processes is to ensure the technology supports a centralised and real-time view of all collateral that exists across the organisation.

The role of big data and analytics

The need to process ever-growing data sets which are high-volume, high-velocity and high variety is not unique to collateral management or financial institutions.  The term “Big Data” is now widely used to categorise the challenges, approaches and tools which have evolved to address this challenge.

Use of such tools can assist with the integration, processing and analysis of the large distributed datasets that contain collateral information across the organisation, providing a consolidated view for collateral optimisation and management purposes. These tools are typically layered over the underlying sources of data, and can therefore be implemented in an evolutionary manner, rather than requiring a complete replacement of existing technology infrastructure. This reduces time to market as well as implementation risk and cost.

While tools and techniques are making big data easier to adopt, its implementation is still not a trivial undertaking, nor is success guaranteed.  With the right business-aligned analysis framework, big data can deliver tangible value to collateral management and the wider organisation.

Collateral optimisation is one area that banks can focus on to reduce the impact of the inevitable interest rate increases.  Firms that grasp this challenge and harness their data effectively will undoubtedly reap the benefits.