- Person 1 - Kathelijne Marritt Alers, Senior Product Manager, SIX
- Person 2 - Darren Marsh, Senior Product Manager, SIX
- Person 3 - Stefano Kerichi, Senior Product Manager, SIX
- Person 4 - Samir Harrouni, Head of Portfolio Data Content Funds, SIX
Kathelijne Marritt Alers: We're talking today about how banks can mitigate their credit risk by using funds as collateral and basically why this could help banks use this for more lending and therefore make more money. To this purpose, I'm being joined by three of my expert colleagues: Stefano Kerichi, Samir Harrouni, and Darren Marsh. The question that we want to focus on today is really how can banks use funds to leverage collateral and therefore free up some capital.
Now, first question: how does this work? What does the Basel framework tell us about this, Darren?
Darren Marsh: Hi Kathelijne, thank you for your question. So, as we know, banks accept collateral against, you know, secured lines of credit, for example. That can take the form of a number of different security types. Credit risk mitigation is actually available to the banks themselves to offset under the Basel framework. There is the ability for them to offset the corresponding counterparty risk and therefore reduce the overall capital charge. So there is, you know, potentially a large benefit for banks because if they repeat that process, they can reduce their overall capital requirements, which in turn means that there's more capital for them to relend or to reinvest.
Kathelijne Marritt Alers: Okay. So usually banks use equity or bonds, or this is the most common way that banks leverage their collateral. What about funds?
Darren Marsh: Yeah, you're right. I mean, you know, high-quality liquid assets usually form the basis of most of the collateral that the banks use. That's primarily due to the fact that they have, you know, favorable credit risk ratings or risk ratings, or that, you know, they're easily priced, so they're liquid. Now, there is the opportunity to also use funds in the same way, but the Basel rules mean that it's a more granular process that the banks have to go through in order to assess the overall eligibility of those instruments. So really what they need to do is they need to look at each of the individual underlying components of the fund to get an assessment of the overall eligibility and then apply the specific haircuts that need to be applied in order to come to the final valuation.
Kathelijne Marritt Alers: Okay. So Stefano, maybe you can help us a bit here. The Basel regulation has been around for quite a while. Has something changed, or is there new things that one should be aware of?
Stefano Kerichi: Yes, thanks for the question, Kathelijne. I think it's a very good one. Actually, yes, as you said, the Basel framework has been around for quite a long time since it was established for the first time in 1988, basically with a purpose of encasing financial stability of the banks and reducing systemic risk. It's something that has been evolving over time. And as you pointed out, there are some changes. At the moment, the EU and Switzerland have implemented the latest wave of changes, and other jurisdictions are due to follow in the next months or years. This is what is called, nicknamed generally, Basel 4 in the EU, Basel III final in Switzerland, Basel 3.1 in the UK, and then my favorite, Basel III endgame in the US.
There are many changes, actually. I would say, just to name one, I think the key aspect here is really focusing on the requirements for the calculation of the risk-weighted assets for credit risk. We know that the banks can basically adopt two different approaches: an internal ratings-based one and the standardized approach. The internal ratings-based approach is essentially based on the risk assessment models which are developed internally by the banks, while the standardized approach, instead, is based on predefined risk weights. And the last one, of course, is easier to implement, but it has a lower degree of flexibility and it has a cost in terms of reduced capital efficiency for the banks.
But now what is really changed and what is really important is that there is now a minimum, let's say, an output floor, so a minimum level of capital that the bank must hold anyway when they adopt the internal ratings-based approach. So there is a minimum limit to the benefit of capital efficiency they can enjoy by resorting to that kind of approach. And this threshold, this minimum amount of capital, is essentially calculated as a percentage of the amount of capital that the same bank would have to hold under the standardized approach. And this percentage is a moving target. It's initially established at 50%, and it's due to increase by 2027 to 72.5%. So that's pretty clear that, based on these changes, it is now absolutely key for the banks to find new ways to become even more capital efficient.
Kathelijne Marritt Alers: Okay. That gives us some clearer view. But maybe, Darren, you can tie that back again to the world of funds and how that would work.
Darren Marsh: Yeah, certainly. So, thinking about how you would approach this from a fund's perspective, in the Basel framework, it stipulates that you have to treat the actual components of the fund as direct investments by the bank. So there is this need to implement something called the look-through approach. And that look-through approach really means that you have to go line by line through the composition of the fund, understand, you know, the eligibility of each of those positions, and then apply the corresponding haircuts as laid down by the standardized approach. So, as you can imagine, it's quite, you know, it can be quite a large process for organizations to deploy on that basis.
So once you've gone through the process of assessing the individual positions, then you come up with an overall collateral value for the fund as a whole and then apply the applicable haircuts. And those haircuts are based on, or volatility adjustments I should say, based on both the price and currency fluctuations that obviously can occur in the market. And then, once you have that, you have the overall. But it does need the granular funds composition information as a first part, and then as a second part, the enrichment information to be able to apply the overall value to the share class. And that needs, you know, quite a bit of heavy lifting as a result.
It really means that, you know, organizations need to collect information directly from source if at all possible, but then they need to, you know, extract, transform, and load that information into something that can be used within the organization. So, you know, there is a real, you know, kind of complex and granular operational piece, and that's really where, you know, data vendors can come into their own, if you like, as organizations that are perfectly positioned within the market. They have the inputs to the asset managers, for example. They collect the information, and then, of course, also have the capabilities around the regulatory enrichment as well. So that really is the main approach, and it's quite clear that, you know, organizations that can deploy that can see quite significant benefits as a result.
Kathelijne Marritt Alers: Okay. Well, before we get to that question on finding out how big those benefits could be, Samir, could you tell us a bit more? So once one has the data, it sounds still like a lot of work.
Samir Harrouni: Yeah, true. But maybe before even delving into the technicalities of how we get the data, I think it's worth mentioning that the fund landscape as a whole went through significant changes over the last, the past decades. At least I'm not going to go into all the details, but at least we have these two major changes: the regulatory trade changes here in Europe. We are all familiar with the UCITS framework, making funds more available and more accessible to retail and institutional, and to clear guidelines. And we have also this cost compression, which is making them again cheaper than they used to be, like 20 or 30 years ago. Both, I'm not only talking about the passive side, both the passive and active funds now are cheaper, and they are a better way to get exposure to equity market or to bond market in a cost-efficient manner.
So this changing landscape is putting funds as a major asset class now. And this is what we are seeing, I think Darren is going to talk about it. This is what we are seeing both on institutional portfolios, but also on retail portfolios. I guess, especially for these Basel 4 funds, if you want to give collateral, you need to know what your retail client has in their portfolio in terms of funds. So this first part is how the fund changed, how the fund landscape changed in the last decades.
To go back to your question about the technicality, it's true that as of today, there is no market standard for gathering line-by-line data. So what we are doing here is really establishing a legal framework. We're putting in place an operational and legal framework to accommodate the various needs of our asset managers and also to be able to tackle the different use cases from our clients. As you know, equity data most of the time is public. Fund data is not. And we are talking about sophisticated mutual funds here. We are talking about some IP, the IP of the asset manager. So we need to give him the comfort to share with us this data under a certain framework. That's why most of the job is to put in place the legal framework and the operational framework before even talking about how we are to clean the data, aggregate it, normalize it, then give it to products like Darren's one to tackle more particularly client use cases.
Kathelijne Marritt Alers: Okay, thank you, Samir. So Darren, yeah, we're hearing more clients and therefore also more banks are holding funds these days. That's what Samir is telling us. He manages to standardize the data, so that's great. Then, how, combining this with the Basel approach, how can we quantify the value that creates?
Darren Marsh: Yeah, absolutely. So, as Stefano alluded to earlier, you talked a lot about the output floor and the increase in risk weights, which basically means that, you know, with the implementation of Basel 4, institutions will have higher capital requirements, and we're actually seeing that at the moment. And of course, institutions are looking at ways to mitigate that increase. So that's, you know, that's the first part. And any opportunity that they have within their implementation projects to look for opportunities as well, then obviously, you know, they're really going to be keen to do that.
You know, the second part of this as well is that, you know, as we know, Basel 4 has now been running for some months, and the banks are, you know, entering into or just finalizing their quarterly cycle of reporting. So, you know, a lot of the implementations will have been tactical to get this over the line. So certainly, in parallel, you know, the same institutions will also be working on strategic implementations, and this is part of the process to help them assess and hopefully deploy some of those opportunities.
I think it's important to emphasize that, you know, if banks are accepting collateral, funds as collateral, and not being able to deploy the look-through approach and therefore credit risk mitigation, then they're potentially leaving money on the table. Really, you know, if they are able to go to that granular detail, then obviously there are opportunities for them, you know, monetary opportunities as well. So, you know, with our solution, banks are able to utilize the offsetting process through the collateral eligibility and really, you know, impact and lower the risk weights and the overall capital requirements for the bank. So, you know, in turn, it just leaves more capital for the organizations to reinvest.
Kathelijne Marritt Alers: Well, that's a really good note to finish on. Thank you, Darren. Thanks also, Stefano and Samir, for some really useful insights, and thanks everyone for joining us.