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Skadi Limited releases trader funding alert #traderfundingrisk

Skadi Limited releases trader funding alert #traderfundingrisk

Nicolas Corry, Managing Director, nicolas.corry@skadilimited.co

On Monday, the Russian Central Bank took bold action, raising interest rates by the most in 16 years. Elsewhere around the Emerging Markets risk premia rose, with a knock on effect to volatility. Interest Rate rises of this kind were witnessed in 1997 and 1998 when Central Banks’ sole objectives were stabilising currencies. What gives us grave concern is that Trader Funding Risk remains, in our eyes, a risk for many banks.

Historically Financial Controllers were responsible for ensuring adequate funding was in place to support traders’ market positions. The responsibility for Cash Management, to give Trader Funding Risk another name, has gradually been handed over to the people trading the underlying assets. Positions resulting from structured trading generally have specific term structures. Funding Risk related to these activities is relatively transparent. Market-making positions and certain proprietary strategies have less certain holding periods and therefore the funding required to support them is of varying term.

Within banks there appears to be little line of sight over the specific Funding Risk traders take. At the macro level Treasury Departments can generally see whether a business is funded, they may be able to see the term, but they cannot relate that to the Market Risk the traders are running and whether it is appropriate. This is because Market Risk is the remit of Market Risk Management. Market Risk limits are generally transparent and well understood. The expectation is that Funding Risk traders take will relate directly to the Market Risk they are running. The assumption is that a limit structure for controlling Funding Risk would be unnecessary. Trader Funding Risk therefore is in danger of falling between the two controls.

A further layer of complexity is added by those businesses able to generate their own funding, either through synthetic trading or certain lending activities. Funding Risk generated in this way can be reflected in the Market Risk Report or the Business’ Funding Report depending on how the positions are booked out. This makes Funding Risk opaque, and indeed this may suit certain traders, particularly those that opt for internal arbitrage strategies, ie generating profits from their own bank’s weak accounting and control. The fact that some traders continue to exploit banks’ internal systems for their own benefit, rather than highlight failings to control functions, reflects the challenge facing banks that are attempting deep cultural change.

Juniorisation of trading teams since the 2008 crisis adds to the risk facing banks. Traders are now used to a long stable low interest rate environment. Traders who began trading in 2009 now have 5 years of experience under their belt, and will likely have significant confidence and trading limits. They have only traded in one interest rate environment and there is a risk that they are unaware of the potential pain sharp rises may cause.

Finally the move in interest rates heightens the risk of trader malfeasance, as traders facing losses in late December will face the temptation of hiding losses to protect bonus payments. With Funding Risk lying outside of the main booking system for many businesses there is double key entry risk, with trades not being booked in both systems, as well as place holder risk i.e. Traders manufacture positions through placeholders relying on large orphan cross bank positions to muddle the control functions.

Hopefully our concerns will not play out, but it would be prudent for Audit Managers to raise awareness within their teams.

Ammunition for the regulation industry

Ammunition for the regulation industry

William Vincent, Senior Consultant, william.vincent@skadilimited.co

The December BIS Quarterly review contains an interesting piece which analyses the performance since 2007 of the three main classes of banks – retail funded, wholesale funded and trading led.

 

Its broad conclusions are:

 

  1. There has been a marked shift away from wholesale funding to retail funding, while the number of trading-led banks has remained constant.

 

  1. Profitability of all three models has fallen sharply, but trading-led banks have suffered the most.

 

  1. Trading-led banks have gone from the most profitable sector, with ROE approaching 20%, in 2007, to the least, with ROE of 5%, in 2013.

 

  1. Trading-led banks have consistently had the highest cost-income ratios, at approximately 70% versus 60% for retail banks and 50% for those which fund mainly in the wholesale markets.

 

  1. Trading-led banks carry significantly more capital, with a capital adequacy ratio of 17.3% versus 14.6% for retail banks and 12.2% for wholesale.

 

So, trading-led banks demand more capital, have significantly higher costs in relation to income, have suffered the most severe fall in profitability, are the least profitable and worst performing of the three groups. However, their numbers have not shrunk to reflect these factors, whereas the number of wholesale-funded banks – which have not performed as badly – has shrunk substantially.

 

The authors of the report surmise that the reason for this is that investment bankers pay themselves so well that they are loath to change their business model – they organise their banks for themselves, in other words, rather than their clients or shareholders. This may or may not be true – after all, past busts have been followed by booms, and banks which closed down or cut too deeply missed out – but the BIS’s view is undoubtedly the one that will gain traction.

 

This will inevitably provide more ammunition for the UK’s politicians and regulators to squeeze the investment banks. Already, they have taken powers for themselves to control what and how bankers are paid, and are imposing limitations on risk that will make it harder than ever for investment banks to produce worthwhile levels of profitability even if and when the good times return.

 

All this means that it is more vital than ever before that banks understand and control their risks (and risk takers), that costs are kept under control and that management is kept fully aware of any business or reputational threat before it blows up into yet another scandal. All in all, therefore, the role of internal audit has never been more important.