Rule Financial

Alec Nelson and David Field examine the challenge of optimising your collateral management

Collateral management is now under sharp focus like never before. Historically a support function, it has come to the fore, in part, due to high profile examples of what can happen if you lose control.

New regulations require banks to demonstrate control of their own and their clients’ assets, and to strengthen their balance sheets by maintaining higher levels of capital adequacy. However, most banks don’t have sophisticated collateral management systems and they are very unlikely to be integrated across the enterprise. Existing collateral management is often manually intensive, time-consuming, error-prone and not scalable.

Many banks manage collateral in business silos: prime services; equity finance; repo and treasury. Recent events have forced banks to introduce new processes and procedures many of which are highly manual due to the lack of technology so collateral management departments are stretched even with today’s volumes. It is therefore difficult to imagine how will they cope as volatility and volumes increase many banks have no clear vision of this. A recent report estimated that $2,000 billion of extra collateral will be needed to meet margin demands for Central Counterparty (CCP) clearing. A ‘squeeze’ of this nature surely means that all banks - even if they do already - must look to further optimise their use of assets.

Common challenges

We often see the same top three collateral challenges for banks:

• inadequate reference data quality - especially the codifying of Legal Agreements and Credit Support Annexes (CSAs) into margin and collateral systems
• entrenched "business silo" based collateral operating models – frustrating the enterprise requirements
• inadequate technology - few banks have the systems integration to rovide the tools required by collateral managers and traders for the new regulatory world

The collateral implications of future regulatory requirements (Dodd Frank, EMIR etc) are still not completely clear, but most banks have concluded they cannot wait and must act now. As well as implications for front, middle and back offices, we are seeing big impacts across a variety of bank functions:

• Risk functions are seeking more transparency into collateral holdings to better calculate exposures
• Legal functions face a huge challenge renewing and renegotiating agreements and CSAs
• Finance functions don’t have the tools or the data to produce "collateral P&L" reports
• New regulatory reporting is anticipated tobecome a significant cost requiring many more people.

Many banks are therefore focusing on the technology around collateral that is needed to stay compliant, control risk and reduce costs but this focus then introduces its own mix of costs, risks and challenges.

A vision for effective collateral management

Banks cannot continue to merely ‘manage’ collateral operations. There is a mountain to climb as banks think through and set clear goals for cross-asset, cross-silo margining and collateral pooling across geographies. We see three levels of maturity for collateral management:

• Foundation – getting the basics right: documentation; pricing and valuation; inventory; reference data; exposure; clearing and settlement; asset servicing and compliance.
• Management – extracting value by improving the operating model; workflow; reporting; risk; reconciliation; availability; trade automation and STP.
• Optimisation – competitive differentiation through re-hypothecation; risk weighted assets/balance sheet optimisation; trader tools and P&L; "what if" scenario/portfolio modelling; risk analysis; collateral optimiser "trading engines".

The collateral operating model

A "collateral operating model" aligns people, processes and technology, informed by: goals and objectives; products and services; organisation; and well-framed controls. Collateral data(ownership, availability, eligibility, cost, priority) must be codified and made available on time to the people and the systems that need it.

The three peaks challenge

True collateral optimisation requires banks to scale the "three peaks", moving from the foundation through management and control, to optimisation - resolving the issues of operational efficiency and business silo fragmentation along the way - in order to deliver real value to the enterprise.

A structured approach

With the complex nature of collateral and its use, all such projects require a well-managed and structured process to ensure success.

Adopting a proven and structured approach for the collateral management journey helps banks to get the results they want by aligning thinking across business divisions and geographies, and between business and technology. This strategic phase of a project is typically followed by a mobilisation and execution phase to deliver the strategy. We call this approach ‘Dynamic Process Modelling’ (DPM™).

Using experienced practitioners trained in DPM™, collateral management improvement projects can be executed quickly and efficiently, maximising communication with key stakeholders whilst minimising distraction of staff from other day-to-day priorities.

Each of the steps results in clear deliverable milestones, demonstrating visible progress at every stage, and ensuring the required improvements occur.

Such a process needs to be supported by architecture modelling and road-mapping tools which can facilitate rapid scenario planning, enabling the bank to evaluate alternative approaches and to quickly make informed decisions on the optimal and bespoke approach for the enterprise.

The ‘Dynamic Process Modelling’ (DPM™) approach

Business direction.

The political challenges of optimising collateral management across diverse business units and geographies should not be underestimated. Whilst ‘bottom-up’ tactical initiatives undoubtedly contribute, banks will fail to fully seize their opportunities unless there is an agreed business vision and direction, such as what constitutes “optimisation”. Direct engagement with senior stakeholders is essential to facilitate.

Operating model.

A new business direction or vision is likely to impact the bank’s operating model. New products and services, such as collateral transformation and client clearing are likely to be created, affecting customers, not least through renegotiating CSAs. Pricing models will be needed to enable collateral pooling or aggregation across business units. Some roles, responsibilities and objectives are likely to be affected and new organisational structures may be needed in addition to the new collateral trading function.

End-to-end processes, activities and controls will undoubtedly change. An effective, fast process for modelling business impact and driving out a target operating model is essential.

Technology model.

The target operating model must be supported by enhanced technology,Beginning with a logical application architecture that supports the new business direction. Utilising derivatives, securities, futures and options etc, will dramatically reduce the time and cost of developing a target architecture for the enterprise.

The new model will incorporate key functions such as eligibility initial and variation margin management, data management, collateral pricing, collateral transformation, re-hypothecation etc. Such a model is invaluable in providing a common language and fostering better understanding, collaboration and partnership between business and technology. An assessment model helps to identify duplicate components ing new components, with decisions captured in a physical application architecture.

Roadmap.

The gap analysis enables identification of Project Building Blocks (PBBs); normally 20-50 units of work with clear objectives to implement the physical architecture and target operating model. This may include further upgrades to existing applications such as Collateral Aggregator. It may also highlight the need for a collateral optimisation engine. There are a number of third party solutions beginning to emerge, hopefully reducing the need for custom development.

Business case.

The roadmap and its PBB components provide a sound basis for the business case. Each PBB can be allocated a cost, resources, duartion and expected benefits, enabling the business case to be created for submission into the budgeting process. The finalised roadmap should be highly informing to the PAR the bank wishes to submit.

Scenario planning.

Business case submission enevitably triggers demand for further refinement, typically by considering alternative scenarios targeted at different goals and outcomes. Examples include testing hypotheses for prioritisation including: reducing year 1 spend; bringing forward business benefits; minimising the impacton customers; avoiding the overload of internal functions; hitting an internal hurdle rate etc. Experience shows that once a PAR is submitted there is a need to create and analyse multiple investment / implementation scenarios until senior level buy-in and sponsorship is established. By ascribing each PBB with not only cost and benefits, but also a business disruption score, customer impact, resource/skill requirements and dependencies, it is possible to rapidly and accurately assemble multiple scenarios to address the concerns and goals of key stakeholders. This is often essential for aligning senior sponsorship for the programme to proceed.

Mobilisation and Execution.

Following the planning and modelling phases of the project, and once stakeholder and budget approval is agreed, the mobilisation and execution phase can commence, leading to the development and implementation of the agreed solution.

Conclusion

Many banks already have some initiatives underway to address elements of collateral management and optimisation,  notwithstanding the uncertainties of Dodd Frank and central clearing. However, there are still many differing strategies, with leading banks adopting greater aspirations to manage collateral on a global basis, across asset class, and across business silos, whilst some are struggling to define what they mean by “optimisation”. What is being optimised: risk? profit? Some view full optimisation as politically too difficult, preferring to focus on single asset classes or primary geographies.

However, it is clear that a structured approach and a material investment in technology is essential - not just to reduce operating costs – but to exploit new opportunities.

_________________________________________________________________________________________To To receive this article as a pdf, simply enter your email address in the 'Send as PDF' box at the top of this page.