Collateral management is no longer an afterthought in the world of derivatives deals. It's an integral and necessary function. So treat those collateral guys well.

By Karen Spinner

Collateral snuck up on the banking world. When few deals required collateral, the task of managing it fell to whoever pulled the short straw. But if importance is measured by the weight of money in banking, then collateral is certainly gaining stature. JP Morgan estimates that there are $60 billion in collateral in the global financial markets supporting derivatives products alone. Clearly, the days of managing collateral on an ad-hoc, product-by-product basis are over for any bank that wants to run a tight risk management shop.

In the "bad old days" of collateral management, collateral often fell under the purview of a back-office clerk who acted as a collateral manager in addition to his other duties. Typically, collateral was not managed centrally, and each department or local office would hold a separate collateral portfolio. There are some serious drawbacks to this approach. Counterparty positions may be infrequently and inconsistently valued, and thus margin calls can be missed entirely. Credit triggers may be only sporadically monitored, lengthening the wait period-and increasing the associated risks-between the time a trigger is activated and when additional collateral is actually demanded.

In the current banking environment, such a passive, decentralized management approach can prove both risky and ineffective in more than just risk-management terms. "A robust collateral department can become part of an active business acquisition process as well as an essential administrative function," says David Maloy, an executive director at SBC Warburg. The components of a successful collateral program include integrated marketing and credit; customer support; and legal, regulatory and technical expertise.

Integrating the collateral department into other bank functions-marketing in particular- is key for any large bank wishing to leverage its collateral know-how. "Collateral should be more than just operations,'' says Brian Wolpert, a vice president at Bankers Trust. A centralized collateral department is the crossroads through which information from credit, marketing, treasury and risk management flows, ensuring that collateral is consistently monitored and managed according to the interests of the entire firm. Collateral specialists should do more than simply receive collateral from counterparties.

This constant communication allows the marketing and sales staff to rely on collateral's expertise to structure and clinch new deals. "There is a perception that collateral is just for lesser credits," says Wolpert. "While collateral is a tool for bolstering credit, it can also be used to create better, more liquid deals." Indeed, as collateral and marketing interact, clients can be presented with new options, including longer tenors and a wider range of structures. "The point," says Wolpert, "is to use collateral as a tool." For example, Maloy of SBC Warburg says he has used collateral in order to increase the bank's comfort level with a variety of offshore/emerging market deals that fall outside the bounds of traditional capital markets.

In the loop

A relationship between credit and collateral is also essential. In particular, the collateral department should understand how the credit area makes decisions. Often, the credit area may have two counterparties with the same credit rating, but may feel more comfortable with one versus the other; collateral needs to know why. Furthermore, the credit area should be involved in drafting the documents outlining the collateral arrangement to ensure clients do not hear different stories from different mouths at the same institution.

Collateral is also an important tool for managing both credit and market risk. Therefore, the collateral area should be familiar with the bank's treasury function and understand the mechanics of risk management. In addition, collateral experts should understand how the markets work, and how considerable market movements can activate credit triggers.

In particular, it is important collateral staffers understand that, in the case of derivatives, market movements can activate credit triggers even if no new transactions are added. Furthermore, treasury, risk management and collateral should work together to coordinate the flow of collateral. "Collateral and treasury can work together in order to avoid triggering major treasury events at their clients' shops," says Wolpert.

For example, a sudden, drastic increase in the amount of collateral required from a counterparty that has experienced a slight downgrade can serve to exacerbate the cash flow and liquidity problems often associated with a dip in credit ratings. Indeed, in some cases, excessive, credit-linked collateral calls can send a customer on a downward spiral, punctuated by further downgrades and margin calls. According to Michael Clarke, a vice president at JP Morgan, "It is important that collateral agreements are structured in advance to ensure that requests for collateral happen in a gradual, step-by-step fashion. You want to avoid a situation where a large collateral call occurs immediately after your customer suffers a rating downgrade, which will just contribute to their liquidity crunch."

Systems integration

While communication and coordination all sound good, they will only work if a bank's various departmental systems are able to share information. Every firm's collateral system should be hooked into the treasury, risk management, credit management and deal management systems. "It is critical that collateral departments know what's going on at all times," says Wolpert, "so they can respond quickly."

This requirement is gaining importance now that credit limits are often tied to the Value-at-Risk of a counterparty's net position. This means that collateral departments will be able to call for (or post) collateral at the time it is required, rather than waiting a day or two to act on outdated information. Collateral departments often grow rapidly following their inception, and technological solutions should be in managers' minds at the outset.

The importance of investing in top-notch systems is matched by investing in highly qualified staff. Many banks are accustomed to selecting a back-office person, virtually at random, and expecting him or her to take on vast new responsibilities. Some collateral specialists suggest that firms instead locate someone with expertise in one of the key areas described above. Banks should aggressively train new collateral hires, exposing them to the other departments with whom they will need to interface and familiarizing them with the big picture.

Additional benefits

In addition to the advantages described above, an effective and centralized collateral management function can yield the following additional benefits.

Cost reduction. An effective collateral management operation helps keep transaction costs down. If more deals are collateralized, then bank capital requirements are reduced, and with them the overall cost of capital. Savings can be passed on to the customer, while capital is freed up for other product lines.

Cross-collateralization. The ability to net collateral requirements across product classes has always been a key goal for the collateral function of a bank. According to Morgan's Clarke, major banks offer cross-collateralization for most products included in the standard ISDA master agreements. The latest development in this area, he explains, is the inclusion of products that may not fall under the purview of these master agreements, allowing the optimization of collateral obligations arising from OTC derivatives, repo transactions and exchange-traded futures and options, to the extent permitted by applicable law and regulation.

No double margining. A centralized collateral department can cut down on the need for double margining for clients. In some cases, clients may have offsetting swaps and exchange-traded instruments. If the positions truly offset each other, then one position will always be in the money while the other position will always be out of the money. But if the collateral requirements on these two positions are not netted out, then the client will have to pay the margins required by the exchange plus bank collateral requirements-hence the double margin.

End re-couponing. When, for example, a counterparty's credit rating moves and thus activates a credit trigger, some agreements call for re-couponing in order to reduce the risk associated with a particular deal. However, if an institution has bilateral collateral arrangement with its counterparties, then it may not be necessary to restructure deals as credit ratings change. Instead, additional collateral could be requested and the client would have the option of leaving the deal's structure unmodified.

Instantaneous collateral updating. A bank can reap substantial risk management benefits from a collateral function that works well. If deals are netted, run through a VAR or similar calculator and tracked by counterparty on a global basis, then it is relatively easy to update collateral requirements on an intraday basis. Thus, collateral can be requested (or returned) as the market moves, eliminating dangerous lags between the time a counterparty exceeds its risk limits and the time it posts additional collateral.

Earning higher returns on centralized pools. When the collateral function is centralized, collateral from different counterparties can be pooled and invested at a higher rate of return. "By centralizing the collateral investment function and, in some cases, pooling collateral where possible without affecting your perfected security interest to make larger investments, our clients can get a pick up in yield," says Clarke.

When setting up an effective collateral management operation, banks need to keep a few additional guidelines in mind.

1. The collateral function must have a central, bank-wide presence.

2. Collateral guidelines and practices must be taken into account at the beginning of a transaction, not just at execution.

3. Clients have to be properly educated. Explaining how collateral works to customers is a critical piece of the collateral puzzle. Often, clients know even less about collateral than the proverbial back-office guy. Without established credit procedures, a deal can be stalled by unproductive back-and-forth hammering out of the operational details. Wolpert explains that a coherent collateral procedure, documentation and staff members who can hold the client's hand during the process can go a long way toward increasing a client's comfort level.

4. Legal details must be ironed out. A collateralized relationship, particularly bilateral collateral arrangements, often require extensive legal documentation. While standardized legal forms are en vogue today, fill-in-the-blank documents must be carefully reviewed, and custom-tailored if necessary. Documents should not specify operational procedures that are virtually unworkable. It is easy to use voluminous documentation to create the illusion of protection. For example, a collateral document might specify that margins are to be posted daily at 10 A.M. when it takes operations until 2 P.M. to complete portfolio valuations. Or, the contract might include a detailed set of credit triggers that nobody in operations is equipped to monitor.