Capital is funding January 25, 2012 at 7:07 am

FT alphaville has a nice riff on the whole systemic risk of margin calls thing, discussing in particular the risk of variation margin calls in the ECB’s LTRO. They quote some Nomura research which makes a number of good points, but one dodgy one. The major thrust first:

The cost of the haircuts and existing funding costs on leveraged banks balance sheets means that the cost of funding from the ECB is not 1%.

True. You fund only 71% of the asset (assuming the collateral is a >5y corporate loan, which gets a 29% haircut at the ECB) at the ECB rate. The rest has to be borrowed unsecured*.

The error comes when the discussion turns to capital:

In this case against a €100 asset there would be a €29 haircut and €5 capital charge giving €34 to fund through other sources.

Nope. The capital charge is funding too. If you have a €5 capital charge on a €100 asset, then 5% of it is equity funded and the rest is debt funded. Thus if the ECB haircut is 29%, you get 71% from the ECB and 5% from your equity investors leaving 24% to raise in the unsecured market.

Now, often people keep ROE separate from ‘cost of funds’, as this separate is typically convenient for reporting; but both equity and debt capital are funding. Thus in this separation the ‘cost of funds’ should be the cost of the debt needed to fund the asset, i.e. interest on €95, not on €100.

*The Alphaville article says ‘Unsecured funding is closed (to all but the bestest of the best), ergo the bank scrapes together assets to pledge for cash somewhere, running the gauntlet of the collateral crunch.’ That isn’t quite it as you don’t fund the haircut of a collateralized asset (the 29%) with more collaterized borrowing. You fund it unsecured, because you have to – you have used 100% of the asset you have to raise 79% of its value. All assets need funding, and there aren’t spare ones lying around to use as collateral as – roughly – anything you can use as collateral is being used to fund itself. This just follows from balance sheets, err, balancing.

One Response to “Capital is funding”

  1. Good point. With the abundance of cheap credit available historically,’All-in’ funding cost was lazily ignored by many CFO’s. If you’re advanced 79& on £100 asset @ 100Bps, your balance sheet still has to fund 21% at whatever your Weighted average cost of capital is (say 600Bps). In this instance all-in funding cost will be around double the external funding cost. Advance rates make a huge difference and WACC will come under greater scrutiny.