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Recently, amidst the unprecedented volatility and asset price
shifts cause by COVID-19, the Funding Valuation Adjustment (FVA)
has become a major source of accounting losses for several US banks
totaling almost $2bn [1]. FVA, which measures the cost (and
benefit) of funding uncollateralized trades, depends largely on two
factors: the exposure on the trades and the funding spread. One
cause of the sudden rise in FVA may be attributed to the lowering
of interest rates by reserve banks around the world. For example,
should a bank have more receiver swaps than payer swaps, then a
lower interest rate will invariably increase the exposure and
consequently the FVA.
The other cause would be a sudden rise in funding spreads. In
the simplest case, when banks enter into an uncollateralized trade
with a counterparty, they simultaneously enter into a
collateralized hedge position with a central counterparty. When the
trade becomes in-the-money, the pledged collateral on the
(out-of-the-money) hedged position earns a risk-free rate but must
be funded at the bank's unsecured rate - the spread between these
two rates is the funding spread.
To investigate the latter cause, we calibrate to the recent FVA
values from our Totem xVA
Service at the 2-, 5- and 10-year tenors for USD and EUR. Note
that, unlike exposures, funding spreads are independent of the
bank's portfolio and capture the state of the lending markets
amongst the major global banks. The calibrated funding spreads
using the in-the-money receiver swap are shown below:
Our results show that, the short end of the funding spreads is
the most sensitive to the recent market conditions. One sees a
similar phenomenon in bank credit spreads - this is reasonable, as
both funding spreads and credit spreads reflect the bank's
riskiness as viewed by lenders (bondholders, in the case of credit
spreads). As an example, a comparison of jumps in the funding
spreads to JP Morgan's credit spreads is shown in Table 1.
Tenor
Totem Calibrated Funding Spread
USD
Totem Calibrated Funding Spread
EUR
JP Morgan
Credit Spread
2 year
226%
398%
552%
5 year
119%
170%
306%
10 year
83%
69%
127%
Table1. Jumps in spreads from February 21
to March 24, 2020.
In addition, the funding spread term structure (not shown) were
upward sloping pre-crisis, but flattened in March, for both USD and
EUR. This is simply an artifact of the short end of the funding
spread term structure jumping more than the long end - a reflection
of liquidity drying up in the short-term funding market. Recall
that in Basel III,
the Net Stable Funding Ratio (NSFR) protocol was designed precisely
to mitigate such scenarios. The calibrated funding spreads
quantifies the risk(s) banks face in their derivative portfolio
management when relying on cheap short-term funding sources to
cover longer dated assets.
Finally, like credit spreads, it appears that funding rates have
peaked in mid-March and are now trending down - the actual peak in
the funding spread, judging from daily quoted credit spreads, was
likely on March 20 when the Federal Reserve of New York
announced a plan to supply $1 trillion a day to the repo
market.
Funding spreads contains vital credit information of the
derivatives market, particularly the liquidity of the interbank
lending market. While the initial shock from the COVID-19 crisis
has appeared to have subsided, whether the New York Fed's recent
intervention is sufficient beyond April remains to be seen - trends
in the future funding spreads will confirm this. For the latest
calibrated funding spreads with comparisons to simulated credit
curves, see
IHS Markit's Financial Risk Analytics Credit Forecasting
Utility.
[1] FVA losses back in spotlight after coronavirus
stress. Risk.net, April 16, 2020
This article was written by Ryo Takei who is on the
Financial Risk Analytics team at IHS Markit
IHS Markit provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.
