This post was written a week ago for www.hnworth.com, a site targeting high net worth individuals in Singapore.
Have fun reading…
********************************
A sharp intern who had worked in the risk department of a European bank once asked me if I thought that anyone really knew how the bank worked, voicing her inner doubts on the capabilities of her superiors. She was a smart cookie who wisely decided to surrender the idea of a career in banking rather than face the prospect of doing something she could not understand which is a poor showing for my efforts at some rudimentary explanations.
The easiest way to imagine how a bank works, really, is to just picture yourself setting up shop and taking your first dollar in deposit.
The dollar would be your liability and you need to put it to work by lending out the dollar at a higher interest rate than what you paid for the deposit. But for conservative reasons, not every single cent from the dollar can be put to work and in Singapore’s case, banks can only lend out somewhere between 13-21% of that monies and it is only logical that they penalise borrowers by passing the cost of the monies retained, presumably at a poorer return.
Simple.
Rules and more rules, of course, are necessary to keep things in order, to prevent the bank from lending depositors hard earned monies to the highest bidder, or lending all their monies kept in call accounts (that can be withdrawn at moment’s notice) for a 30 year mortgage and such. All too necessary with centuries of bank failures to prove for it as banks chased profits because bank managers were paid a portion of those profits and preying on the instinct of human greed, which is perhaps the easiest job in the world.
As rules got more complex, banks strode ahead with some so called off balance sheet items, the most commonly known one as being the foreign exchange swap which does not add to the balance sheet of the bank, being a simple buy and sell of one currency for another between 2 different points in time. And thus, we have the first derivative contract – a product that is derived from an underlying asset – which in this case is a simple one of the differentials between 2 interest rates.
As long as an underlying exist, it is possible to derive an earthquake index, or even a cherry blossom index for tour agencies reliant on the the timing of the blossoms for their dear livelihoods.
Bankers are no longer bankers but financial engineers these days and so good are they at that “numbers game”, that it is possible to make money from anything as long as you have an underlying to trade and derivatives, like bonds, are OTC products which means that they are arms length transactions between 2 counterparts gentleman style.
It is an endless game of cat and mouse between regulators and banks which culminated in the Lehman crisis or the Global Financial Crisis (“GFC”) where Lehman Brothers, a 158 year old institution, collapsed from its inability to honour its debts due to its inability to raise more debt which would have saved it, had they managed to borrow in time.
Ingenuity struck during the crisis as banks found themselves short on the profit front and facing massive shortfalls in regulatory capital, as necessity is the mother of invention and the need to survive prevailed and “profits” (or rather profitable reserves) came from the most unlikely source, the devaluation of their liabilities because bank debt/bond prices fell which allowed some gains in the form of debt valuation adjustment (DVA). Therefore, instead of recognising their liabilities as 100, it was possible to recognise that they only owed 90 cents from prevailing market prices, 10 cents “profit” ?
Thus the regulators brought on the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010, with the main aim of main street protection, increasing transparency and accountability in the marketplace. Part of the new regulations required increased capital surcharges and sufficient collateralisation on their derivative contracts which meant most standard derivatives had to be centrally cleared, no bank in the world unexempted, if they wished to do any business with an US entity and bank.
And given that US banks are mainstay for market liquidity in global banks and derivatives, there is little choice.
When they ran out of DVA, in stepped the FVA back in 2012, the funding valuation adjustment which was basically recognising that they could borrow cheap again.
Then the CollVA and IMVA came about – Collateral Valuation Adjustment and the Initial Margin Valuation Adjustment, when banks realised they could save capital by playing around with the type of collateral they posted and received for their derivative trades.
I recall my dear friend, a derivatives and bond trader, lamenting to me that she had to not only consider the interest rates when trading but the collateral type as well. It is well possible to make profits by dealing at the same price between 2 counterparts, a buy and sell trade simultaneously, just based on the difference between the collateral they posted and foreign banks loved their Singaporean counterparts for their SGD dollar collateral then even if the Singapore local banks were blissfully unaware, then, that there was such a profit to be made.
Another friend had this to say last year.
“The state of the art today is:
1. For pricing, you use CVA and FVA
2. For accounting, you use CVA, DVA and FVA.
To be precise IFRS 13 only requires you to report CVA and DVA. JP Morgan under the leadership of Jamie Dimon reports FVA in addition to CVA and DVA. You will see why this makes perfect sense in a moment.