Albanese: crushing capital costs

After helping devise a method for banks to severely reduce their derivatives funding costs, Claudio Albanese of analytics vendor Global Valuation now wants to reshape how dealers approach capital optimisation

claudio-albanese-2015
Claudio Albanese

Banks have overestimated the costs in their uncollateralised derivatives positions by billions of dollars, and the subsequent write-offs should have gone through capital and not earnings – this was the conclusion of a controversial paper written by two quants earlier this year (Risk February 2015).

But when London-based Claudio Albanese, chief executive officer of analytics vendor Global Valuation, set out to write the paper with colleague Stefano Iabichino and Leif Andersen, of Bank of America Merrill Lynch, he says they were not expecting to discover a way to dramatically cut banks' funding valuation adjustment (FVA) costs – they just wanted to clean up current methodology.

"We really wanted to have a clean story without unnecessary approximations. It is coincidental that the FVA turned out to be much smaller than what you would get otherwise. The point is the number is right and more rigorous, even to academic standards – that was the original motivation," says Albanese.

Between 2012 and early 2015, 24 banks took a collective $6.2 billion of losses when they revalued their uncollateralised derivatives positions to incorporate FVA. The paper challenged the existing methodology, and claimed dealers had overstated the losses by up to $4 billion (Risk April 2015).

Reduced charges

The new approach minimises funding costs by netting down funding costs and benefits at the portfolio level, instead of calculating separate funding costs and benefits at each netting set level and adding them up. These FVA charges can be reduced even further if capital is used as a funding source, Albanese and Andersen argue in a new paper. Albanese says five major dealers are already working with his company to implement the new methodology.

Another area Albanese is looking at is capital optimisation, in particular how best to offset capital requirements across internal desks and with certain clients. This involves identifying positions with offsetting exposures and entering into new trades between them, reducing capital requirements in the process.

Finding these offset opportunities can be a labour-intensive process, however: "You may have a trader sitting at the US dollar swap desk who wouldn't know anything about what is going on in the euro/dollar desk but there might be a cross-selling opportunity between the two. So the technical problem is how to detect those trades and take action. It is not really efficient for traders to call each other on the phone asking if a trade will suit them," says Albanese.

To achieve this, Albanese has returned to the global valuation technique he helped develop in 2010, which values trades across asset classes and views risk at a global level (Risk July 2010). At the time, the method was criticised for its complexity, but the growing push to calculate capital valuation adjustments (KVA), which estimate the lifetime cost of capital for new derivatives trades, has given the technique a new lease on life (Risk September 2015).

This technique enables banks to calculate KVA due to its ability to run billions of scenarios, aggregated on a global basis. Banks can then detect cross-selling opportunities in real time by looking at the incremental cost of capital for a portfolio, he claims.

In practice, this would allow a bank to identify a trade that could be put on between the US dollar swap desk and euro/dollar desk that would reduce capital requirements for the bank at a wider portfolio level, instead of just looking at desk-level impacts.

"KVA is really the number that gives you all this information. You need a system that can capture a big portfolio across several desks and you need to be able to simulate going forward not only the valuation of the trades but also the adjustments and the capital requirements. Once you do that, you basically have all the ingredients to help you quantify lifetime capital consumption of a trade in a portfolio context," says Albanese.

While the move requires a lot of heavy lifting from banks to implement, Albanese says that in the long run, it will pay off. "Market makers are coming to terms with the fact that they need to optimise their portfolio. I think the ability to retain and conquer market share while generating attractive and sustainable profits for shareholders will make the difference between winners and losers," says Albanese.


Biography – Claudio Albanese
2006-present: Chief executive of Global Valuation
2006-2013: Non-executive director, Carador income fund
2004-2007: Professor of mathematical finance, Imperial College
1994-2004: Associate professor, Mathematics department, University of Toronto
1998-1999: Vice-president at the derivatives products group, fixed-income division, Morgan Stanley Dean Witter
1991-1994: Senior research associate, Institute for theoretical physics, Swiss Federal Institute of Technology – Zurich

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