can have benefits and drawbacks for the controllers left onshore. The most significant benefit for onshore controllers is the quantity of production work left onshore will be significantly less. This change should now free up time for onshore controllers to perform more analytical work.
The type of analytical work can vary at each bank, but typically the controller will analyse those components of the financials which can have a significant influence on the behaviour of the desk. This can vary quarter by quarter, but some examples include balance sheet usage, brokerage fees, capital, liquidity, return on assets, and so on.
Additionally, the controller will spend more time analysing the health of the control framework in finance to ensure the level of operational risk is not excessive. You could say that this role is becoming more akin to a CFO role.
The reality of a trading environment means additional work will always arise, yet cannot be anticipated. The main drawback for onshore staff post-offshoring is how to meet the demands of their new role with a reduced headcount.
As previously they were the controllers running reports and performing checks, but now they are receiving a finished product from their offshore colleagues and assessing its quality, this change throws up a need for onshore controllers to adapt and grow. This requires a different skill set and it can be quite frustrating at first, especially when the offshore person performing the work may have far less experience than they do. This change is a transitory period and the frustration should ease with time as respect and rapport between the onshore and offshore teams grows.
In addition to this, the question a bank must ask themselves is where will the next generation of onshore product controllers emerge from? From experience, I know that it can be difficult to manage a product control team effectively when you have no experience of the bank's systems and controls, let alone if you have no product control experience.
I expect the offshore and near shore controllers to grow in experience and take on more of the responsibilities that used to reside onshore. In this case, the onshore product control team as we now know it will become extinct and will be replaced by a pure CFO role.
XVA
Another of the significant changes for product control centres around the valuation adjustments now being made to OTC derivatives and funding liabilities where the fair value option is elected.
XVA is the collective acronym used for valuation adjustments such as counterparty credit (CVA), own credit (DVA), funding uncollateralized derivatives (FVA), margin (MVA) and capital (KVA). This list continues to grow and VAs continue to be refined over time.
Although CVA and DVA were pricing considerations before the GFC, the GFC elevated their importance as the cost of credit risk rose significantly. This change affected both OTC derivatives and fair valued funding liabilities.
FVA emerged during the GFC when, also due to the spike in credit risk, OIS (overnight indexed swaps) and LIBOR (London Interbank Offered Rate) yields dislocated and their basis widened. Traders were forced to capture the cost or benefit of funding uncollateralized derivatives into their OTC derivatives.
In response to these developments, banks established trading desks dedicated to the pricing and risk management of CVA/DVA and FVA, often referred to as the XVA desk.
As the desk started to price these different costs and benefits into their transactions and manage the resulting risk, product control not only needed to understand these valuation adjustments, but were also required to embed the valuation adjustments in the finance layer. Such changes elevated the importance of the valuation controllers, whose technical skills were required to embed the new VAs successfully.
We will look at XVA further in Chapter 16.
Greater Levels of Capital
During the GFC it became very evident that banks were not maintaining enough capital to absorb trading losses caused by the significant fluctuations in financial markets and the credit events of companies such as Lehman Brothers. This capital deficiency resulted in many banks having to seek support from their governments to prevent their collapse.
Governments across the world were very aware of their need to protect the savings of investors and prevent the crisis from damaging real businesses (i.e., companies outside of financial services, such as manufacturers, retail, etc.) which require loans from banks to fund their working capital and investments. Consequently, the reaction from governments was significant. For example, in the United States the government passed legislation, the Emergency Economic Stabilization Act 2008, to support the purchase of up to $700 billion of troubled assets from banks (TARP). In Australia, the banks benefited from the government's guarantee on deposits and wholesale funding requirements for Australian deposit-taking institutions. Governments across Europe also effected similar measures.
As a result of this shock, the Bank for International Settlements (BIS) commenced with the design of Basel III, which sought to address the shortcomings in capital requirements that occurred during the GFC. If we fast-forward to today, we can observe that through Basel III, the Fundamental Review of the Trading Book (FRTB) and independent regulatory intervention, the levels of capital that banks now (and will) hold are higher than prior to the GFC. This has forced banks to be more deliberate about the size and quality of their assets, credit risk and the size and complexity of their market risk.
The businesses Product Control support are now being evaluated not only on their accounting P&L, but also on their P&L performance after considering capital costs. There are various measurements used in the industry to assess capital adjusted returns, one measure is economic P&L. Economic P&L takes a business's net operating profit after tax (NPAT) and deducts a cost of capital.
Economic P&L = NPAT − (capital employed × cost of capital)
NPAT is the P&L product control report to the desk after being adjusted for tax and non-trading costs. The cost of capital is the cost of maintaining the necessary levels of debt and equity that comprise the capital base.
For example, if a bank has issued $1 billion of ordinary shares, the cost of this capital is the return shareholders require on their equity investment in the bank (i.e., dividends and capital growth). That return is market driven and may be a per annum amount of 10 %, 12 %, 15 % and so on. For example, the rates desk used $200 million of capital to invest in sales and trading activities, which generated an NPAT of $80 million for the year. If the cost of capital is deemed to be 10 %, the economic P&L for the year would be:
As capital levels generally rise with increased risk, if a business increases risk, such as taking on more risk weighted assets, it will place downward pressure on economic P&L (as depicted in Figure 2.3).
Figure 2.3 The impact of increased capital
This focus on capital has led to product control spending more time reviewing the balance sheet, identifying and explaining significant changes in risk-weighted assets (RWA) and partnering with the business to help reduce unwanted increases in the balance sheet.
Greater Focus on Liquidity
Like any company, a bank needs a certain level of cash to operate, but during the GFC, the financial markets experienced prolonged periods of illiquidity. During this time, Northern Rock, a British bank, could not continue operating as their interbank counterparts ceased providing loans, and retail depositors withdrew their money in vast sums. This is known as a run on the bank. As a result of this
