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Basis risk

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Published: 16th March 2011 by William Webster

Basis risk - an update

It's a salutary fact that the regulator has identified that firms that run relatively large basis risks are more prone to margin compression. That's because excessive basis risk reduces your control over the balance sheet and calls into question your risk management and governance.

Ask a trader about basis risk and they will tell you it is to do with ineffective hedging. You may think of it as the risk between Libor and Bank rate. The fact is basis risk means different things to different people. So let's define it.

In the following article basis risk is "the degree of control you have over the margins in your balance sheet". This may seem an unusual definition but all will become apparent.

Categorising the balance sheet

For simple businesses the regulator considers that the balance sheet is made up of assets and liabilities that can be categorised as falling into one of four books. They are:

Administered: These are assets or liabilities that have rates set by the firm. They are therefore controlled by the firm albeit that they are influenced by competitors. Examples include standard variable rate mortgages and deposit rates that are at the firm's discretion.

Bank rate: These are assets or liabilities that have rates set by the Bank of England. They are therefore outside the firm's control. Examples include mortgages and savings accounts that track Bank rate.

LIBOR: These are assets or liabilities that have rates set by the market. They are therefore outside the firm's control. Examples include coupons on FRNs and MTNs, interbank loans and deposits and the Libor payments on swaps.

Fixed: These rates are determined from the outset. Having been fixed they are outside the firm's control. Examples include fixed rate savings and fixed rate mortgages.

Why is this categorisation important? Because the relative mixture of assets and liabilities in these categories will influence the degree of control you have over interest income and expense and therefore your net interest income. There are two reasons why the degree of control you have can become limited.

1. Insufficient Administered assets and liabilities

Suppose you need to cover losses that have occurred elsewhere in the business or you just want to make more money in order to increase capital or reserves. How can you do this? The simple answer is to increase the net interest income. (You could either receive more interest on assets and/or pay less interest on liabilities). But only Administered rates allow you to do this because you do not have control of the rates in the other categories.

If all of your assets and liabilities are Administered then a relatively small adjustment to those Administered rates should suffice. Your competitive position in the market should not be seriously affected.

However if the proportion of Administered assets and liabilities in your balance sheet is small the adjustment to those Administered rates must be correspondingly large and you are in danger of pricing yourself out of the market.

To reinforce this point you may have a perfectly matched balance sheet. Your Libor, Bank rate and Fixed rate assets and liabilities all match and your risk reporting shows no exposure. So where is the difficulty? There is none unless unexpected losses need you to alter margins. You simply can't do it until the assets and liabilities mature.

In this sense administered rates are "good thing" because they give you control over margins. Whether you decide to exercise this is entirely up to you.

2. The correlation problem

Correlation is a statistical measure of how closely things are connected to each other. It becomes a problem when you make assumptions. This can lead to risk.  Suppose you believe that Libor and Bank rate are closely related. You become tempted to think that mismatches in the categories of interest you pay and receive are not risky.

In the 2007 crisis if you received Libor and paid Bank rate you would have made money because the difference between Libor and Bank rate widened.

But if you had wholesale funding that financed a mortgage book linked to Bank rate you would have incurred losses.

This problem is not limited to Libor and Bank rate exposures. It can occur where you have mismatches between the various categories. This include mismatches against Administered rates because although you have much more flexibility over Administered rates presumably there will be times when you prefer not exercise that flexibility.

Mismatches create risks. Those risks may lead to windfall gains or losses depending on what happens.

How much risk should you run?

Perhaps this is best looked at from slightly different perspectives.

Limits on the administered book: To recap, Administered rate assets and liabilities are helpful in so much that you have flexibility over your margins. The time you may want to exercise that flexibility is when you need additional income to cover weak performance or losses. But widening margins can affect your competitive position and ability to write new business. Furthermore greater adjustment of the Administered rates must occur if you have a relatively low proportion of Administered assets and liabilities.

With this in mind it is not hard to run through scenarios and their potential effect on margins. You are now in a better position to consider the minimum proportion of assets and liabilities that should be of the Administered rate type. This minimum then becomes a limit.

Limits on mismatches:  To recap, where Bank rate, Libor and fixed rate assets and liabilities do not match then a net exposure will prevail. This net exposure can cause you pain or gain.

In terms of risk management the pain needs to be managed. The FSA suggests it is prudent to have separate limits for each net exposure. This can be done by putting a limit on the mismatch for Bank rate, Libor and Fixed rate exposures so they do not exceed a percentage of the balance sheet size, (SDLs for Building Societies).

To refine this approach it is worth considering how much it could cost your business if the net mismatch position went against you.

For example if you are a net payer or receiver of Libor what would it cost you if Libor moved one basis point against you and stayed like that?

Libor can move independently of other rates by more than 150 basis points. This can give you an idea of the volatility of the risk you are facing. Limits should reflect this volatility and your tolerance to it.

Why is basis risk on the regulatory agenda?

The answer is straight forward. The regulator wants to know you are in control of the balance sheet. That's why basis risk is an issue that requires board discussion. Proper reporting in board packs should facilitate this.

Should the risks you have turn out to be excessive remedial action is required. This can take place over time by changing the business you do and the products you offer.

Failure to do this leads to earnings of poor quality and questions governance because you are prone to margin compression.

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