Try before you dive
01 October 2013
State Street’s managing director Glenn Horner, and vice presidents Leslie Levine and Jeffrey Trencher, explain new approaches to liquidity risk management
Image: Shutterstock
Securities lending programmes, like most investment strategies, pose certain risks, many of which have been generally well-managed for decades by market participants. The global financial crisis, however, highlighted the arguably underestimated scale of liquidity risk in the industry. Since that time, industry participants have sought better ways to measure liquidity risk to improve how they structure and manage lending programmes to suit lenders’ individual risk profiles.
Liquidity risk for lenders became a particular concern amid the volatile equity markets of the crisis period. Equity market declines exceeded 40 percent, borrowing demand dropped and the short-term fixed income market faltered. These developments exerted pressure on the liquidity of cash reinvestment pools by rapidly drawing down available cash from maturing assets and lowering the market prices of some of the pools’ underlying assets.
Lenders historically have appreciated the stand-alone market risk of changing asset values in their investment portfolios, including their collateral reinvestment portfolios, and have sought to mitigate that risk through their choice of investment guidelines. However, the financial crisis emphasised the potential cascading impact of rapidly declining loan balances alongside changes in asset market values in their collateral investment portfolios. The experience showed the need for new ways to empirically measure loan balance volatility, just as lenders evaluate other types of risk. With this need in mind, analysts at State Street (including its research arm, State Street Associates) have introduced a tool to measure the ‘loan portfolio balance-at-risk’ to help lenders understand and measure liquidity risk.
This tool allows lenders to evaluate how potential fluctuations—in both the market value of securities on loan and in the overall demand to borrow—may affect their cash collateral reinvestment portfolios. Such metrics can help lenders make sounder decisions for how they structure their lending programmes.
Collateral reinvestment and liquidity risk
To better understand the significance of loan portfolio balance-at-risk for helping lenders assess liquidity risk, it helps to review the role that cash collateral reinvestment plays in securities lending. Ideally, an institutional investor’s lending program makes the investor’s securities portfolio more productive by enabling the investor to earn additional income. Risk is mitigated by the borrower securing loans with collateral that is at least equal to the value of the loans. The level of collateral required fluctuates daily according to the market value of securities lent.
In the case of cash collateral, a lender re-invests it in short-term fixed income assets and pays the borrower a rebate representing interest (negotiated specifically for each transaction) on the cash used as collateral. A lender earns income, typically shared with an agent, from the spread between the collateral portfolio’s earnings and the rebate paid to the borrower. When a loan is terminated, the securities are returned to the lender, which then is obligated to return all of the cash collateral to the borrower.
As this basic review of a cash-collateralised securities lending transaction shows, the relationship between an investor’s loan portfolio and its reinvestment portfolio plays an important part in liquidity risk management. At inception, the value of both portfolios will balance, aside from any collateral margin. However, as the loan portfolio rises or falls in value, the reinvestment portfolio manager will need to revise the invested collateral position accordingly.
Meeting liquidity needs
The financial crisis starkly highlighted the potential vulnerability of the interrelationship between the loan and collateral portfolios. During the crisis, rapidly declining equity markets and reduced borrower leverage lowered the market value of securities on loan. Their combined impact quickly used up reinvestment vehicle liquidity from maturing securities. As a result, some lenders faced lending additional securities on unfavorable rebate terms and/or selling, at a loss, reinvestment assets that had dropped in value because of widening credit spreads. What can we learn from this?
To meet liquidity needs over a given period of time, a reinvestment portfolio manager needs to consider the loan portfolio balance-at-risk, and collateral liquidity.
The loan portfolio balance-at-risk takes into account two factors that lie beyond a lender’s control: market price changes for the securities on loan and shifts in the volume of securities on loan (also referred to as utilisation). How quickly, and to what extent, these changes may occur will vary depending on the make-up of the loan portfolio. Collateral liquidity refers to the portion of collateral that matures over a given period of time. When the reinvestment portfolio has insufficient cash from maturing assets, the manager may need to sell assets to cover collateral return needs. Volatility in interest rates and credit spreads may result in losses.
An analytical approach
Lenders can estimate their loan portfolio balance-at-risk over a given period by calculating a simulated 99 percent draw-down path of their loan portfolios. With that data, lenders can also estimate the expected liquidity buffer of their reinvestment portfolio, ie, they can estimate the expected need to sell assets in order to return collateral held against a shrinking loan portfolio. The 99th percentile drawdown path looks at the current composition of the loan portfolio and considers the underlying securities’ price volatility and historical changes in the demand to borrow like securities (see Figure 1).
A sample analysis considers a typical loan portfolio (see Figure 2) and, using benchmark indices, estimates the potential change in value of the loan portfolio by using historical data of both price changes and borrower demand for the loaned securities.
Based on the empirical data, a lender can identify the expected percentage change in its loan portfolio at a desired confidence level, 99 percent in the example shown (see Figure 3).
This advanced analytical approach offers an important means to measure an estimated 99 percent drawdown path for loan balances. As a result, lenders may be better situated to assess whether their current cash collateral reinvestment guidelines are well-suited to their overall risk profile given the assets that they lend.
Liquidity risk for lenders became a particular concern amid the volatile equity markets of the crisis period. Equity market declines exceeded 40 percent, borrowing demand dropped and the short-term fixed income market faltered. These developments exerted pressure on the liquidity of cash reinvestment pools by rapidly drawing down available cash from maturing assets and lowering the market prices of some of the pools’ underlying assets.
Lenders historically have appreciated the stand-alone market risk of changing asset values in their investment portfolios, including their collateral reinvestment portfolios, and have sought to mitigate that risk through their choice of investment guidelines. However, the financial crisis emphasised the potential cascading impact of rapidly declining loan balances alongside changes in asset market values in their collateral investment portfolios. The experience showed the need for new ways to empirically measure loan balance volatility, just as lenders evaluate other types of risk. With this need in mind, analysts at State Street (including its research arm, State Street Associates) have introduced a tool to measure the ‘loan portfolio balance-at-risk’ to help lenders understand and measure liquidity risk.
This tool allows lenders to evaluate how potential fluctuations—in both the market value of securities on loan and in the overall demand to borrow—may affect their cash collateral reinvestment portfolios. Such metrics can help lenders make sounder decisions for how they structure their lending programmes.
Collateral reinvestment and liquidity risk
To better understand the significance of loan portfolio balance-at-risk for helping lenders assess liquidity risk, it helps to review the role that cash collateral reinvestment plays in securities lending. Ideally, an institutional investor’s lending program makes the investor’s securities portfolio more productive by enabling the investor to earn additional income. Risk is mitigated by the borrower securing loans with collateral that is at least equal to the value of the loans. The level of collateral required fluctuates daily according to the market value of securities lent.
In the case of cash collateral, a lender re-invests it in short-term fixed income assets and pays the borrower a rebate representing interest (negotiated specifically for each transaction) on the cash used as collateral. A lender earns income, typically shared with an agent, from the spread between the collateral portfolio’s earnings and the rebate paid to the borrower. When a loan is terminated, the securities are returned to the lender, which then is obligated to return all of the cash collateral to the borrower.
As this basic review of a cash-collateralised securities lending transaction shows, the relationship between an investor’s loan portfolio and its reinvestment portfolio plays an important part in liquidity risk management. At inception, the value of both portfolios will balance, aside from any collateral margin. However, as the loan portfolio rises or falls in value, the reinvestment portfolio manager will need to revise the invested collateral position accordingly.
Meeting liquidity needs
The financial crisis starkly highlighted the potential vulnerability of the interrelationship between the loan and collateral portfolios. During the crisis, rapidly declining equity markets and reduced borrower leverage lowered the market value of securities on loan. Their combined impact quickly used up reinvestment vehicle liquidity from maturing securities. As a result, some lenders faced lending additional securities on unfavorable rebate terms and/or selling, at a loss, reinvestment assets that had dropped in value because of widening credit spreads. What can we learn from this?
To meet liquidity needs over a given period of time, a reinvestment portfolio manager needs to consider the loan portfolio balance-at-risk, and collateral liquidity.
The loan portfolio balance-at-risk takes into account two factors that lie beyond a lender’s control: market price changes for the securities on loan and shifts in the volume of securities on loan (also referred to as utilisation). How quickly, and to what extent, these changes may occur will vary depending on the make-up of the loan portfolio. Collateral liquidity refers to the portion of collateral that matures over a given period of time. When the reinvestment portfolio has insufficient cash from maturing assets, the manager may need to sell assets to cover collateral return needs. Volatility in interest rates and credit spreads may result in losses.
An analytical approach
Lenders can estimate their loan portfolio balance-at-risk over a given period by calculating a simulated 99 percent draw-down path of their loan portfolios. With that data, lenders can also estimate the expected liquidity buffer of their reinvestment portfolio, ie, they can estimate the expected need to sell assets in order to return collateral held against a shrinking loan portfolio. The 99th percentile drawdown path looks at the current composition of the loan portfolio and considers the underlying securities’ price volatility and historical changes in the demand to borrow like securities (see Figure 1).
A sample analysis considers a typical loan portfolio (see Figure 2) and, using benchmark indices, estimates the potential change in value of the loan portfolio by using historical data of both price changes and borrower demand for the loaned securities.
Based on the empirical data, a lender can identify the expected percentage change in its loan portfolio at a desired confidence level, 99 percent in the example shown (see Figure 3).
This advanced analytical approach offers an important means to measure an estimated 99 percent drawdown path for loan balances. As a result, lenders may be better situated to assess whether their current cash collateral reinvestment guidelines are well-suited to their overall risk profile given the assets that they lend.
NO FEE, NO RISK
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
100% ON RETURNS If you invest in only one securities finance news source this year, make sure it is your free subscription to Securities Finance Times
