How Funds Can Become a Capital-Efficient Alternative as Collateral

With effective credit risk mitigation, financial institutions can better leverage non-cash collateral, effectively reduce credit risk positions, and make more capital available for business. This includes being able to identify the collateral and assess it.

Financial institutions can reduce their credit risk by accepting non-cash assets from counterparties as collateral. This strategy minimizes the risk of losses due to payment defaults, helping maintain financial stability and profitability even if customers cannot meet their obligations.

In addition, prudential regulatory frameworks require that financial institutions hold sufficient capital, ensure liquidity, and thus reduce systemic risk. The Basel accords, for example, have been significantly revised and updated in the aftermath of the global financial crisis of 2008.

The more non-cash assets that can be identified and valued, the greater the opportunity to reduce individual credit risk exposures and, in turn, lower the overall requirements for the regulatory capital that a financial institution must hold.

In addition to real estate or vehicles, securities in particular can be considered as collateral for bank loans. This typically includes high-quality stocks and bonds as they are liquid and easy to mark to market.

However, holdings in funds, such as mutual funds and exchange-traded funds, are also permitted as eligible collateral subject to Basel rules. Funds as collateral in lending transactions have so far led a niche existence but could prove to be an attractive alternative in the wake of the rollout of the final transposition of the accords. 

It is clear that Basel III/IV forms the basis for a stricter view of the risks financial institutions are exposed to. The introduction of additional risk sensitivities will result in higher risk weights for some exposures. The pricing of collateral in securities financing will need to be adjusted to mitigate the increase in minimum capital requirements.

Conversely, the regulations show how individual credit risk exposures can be mitigated to optimize the financial institution’s overall capital position. As already mentioned, liquid assets such as high-quality shares or bonds make up the largest proportion of non-cash collateral. However, funds can also be considered high-quality collateral provided they meet the conditions laid out under the Basel framework. One prerequisite for this is the ability to determine the haircut of a fund.

To determine the haircut, i.e., to value the fund positions that financial institutions have received as collateral from borrowers, they can use the mandate-based approach. However, this approach is only a conservative estimation based on the stated investment profile of the fund. As such, it does not allow for the most efficient use of capital. Financial institutions are giving away potential that they could use elsewhere.

The most capital-efficient method for assessing funds under the standardized approach, suggested in the Basel framework, is by implementing the Look-through Approach (LTA). By adopting the LTA, financial institutions that accept funds as collateral can improve the risk weighting of the banking book and thus have a positive influence on capital requirements.

As an effect of this, more capital is freed up to carry out yield transactions. The more often and systematically a financial institution uses the LTA in connection with funds, the more capital is available for further loans or investments.

However, the LTA entails identifying each component of a fund as a direct investment i.e., as if each underlying component were held as an individual position by the financial institution.

The haircut for the fund as a whole can only be determined by the average haircut of all the assets underlying the fund. Not an easy task, considering that a fund naturally consists of many different components, each of which needs to be accurately identified and assessed.

Therefore, when using the LTA, the financial institution needs to identify the underlying assets and their corresponding weights and assess the eligibility of each position before being able to apply the corresponding volatility adjustments – or haircuts. The more precisely this can be done, the lower the overall haircut will be for the fund.

While the LTA is recognized as the most capital-efficient approach, it is also a data- and resource-intensive process. It requires granular data collection and normalization from multiple asset managers, which impacts IT resources and costs.

As a result, some financial institutions often resort to manually collecting the data required for the LTA through so-called scraping, i.e., retrieving data from asset management websites. This method is not only inefficient, but also prone to producing inaccurate and outdated data.

If financial institutions want to allow funds as collateral and use them in a capital-efficient manner, this is only achievable through the LTA. Moreover, employing the LTA in connection with funds requires granular data and automated processes. This goes hand in hand with aggregating and normalizing data in various formats directly from the asset managers.

This is where data providers come into play. Through their connections to the relevant players and their expertise they are able to continuously aggregate and normalize the data on the affected assets in an automated manner.

By combining this core competence with the necessary Basel data enrichment, they can provide a financial institution with all the granular information needed to comprehensively and timely value the funds, in accordance with the regulatory requirements.

Thus, accepting funds as collateral is no longer a challenge for financial institutions, but an opportunity.