A discussion and exploration into cross currency basis risk

A discussion and exploration into cross currency basis risk

By Dimitrios Papathanasiou, Head of EMEA Treasury and Liquidity risk, Credit Suisse

Can you please tell the Risk Insights readers a little bit about yourself, your experiences and what your current professional focus is?

I work in Credit Suisse and I am the Head of Treasury and liquidity risk in EMEA. I am providing risk services to the organization on the liquidity risk of the bank, but also on the market risk from the Treasury transactions. In my career I have done several roles from treasury audits to trading in different financial institutions. I also worked as the Head of the Front Office in Treasury in Coca Cola Hellenic for 6 years.

What, for you, are the benefits of attending a conference like the Liquidity Risk Management Forum and what can attendees expect to learn from your session?

I found very interesting the mix of people who present. In general I am expecting like last year very interactive sessions with interesting topics. I like the fact that this conference is only 1 day and focuses on areas that the Treasury industry is mostly interested.

I think that there are many areas that would be interesting: First of all we will spend some time to understand what is the cross currency basis risk and then to look the history during different periods and in different currencies. It is very interesting to see for example that the EUR basis vs the USD spread is quite similar with the CHF basis in most of the periods without crisis. But when crisis erupts they might have very material differences. Then we will look on the processes that the banks should have to manage the risk.

Without giving too much away, what is cross currency basis risk?

It is basically the risk that the banks have when they fund mainly USD assets with liabilities in different currencies. It is translated as a basis spread added mainly to the US Dollar London Interbank Offered Rate (USD LIBOR) when the USD is funded via foreign FX swaps using different currencies such as the EUR or JPY.

The cross currency basis risk could trigger arbitrage trades, but the restrictions on the balance sheet do not allow banks to take full advantage of these opportunities.

In your opinion, how can we look to effectively measure and manage the cross currency basis risk?

In terms of measurement, the BR01 (value on a 1 basis point move of the spread) is a key metric that would help someone to measure how much risk he could lose. This is quite simple to the DV01 calculation depending on the instrument as it finally translates to an interest rate risk price. Scenario analysis and stress testing are also important tools in order to understand the potential loss.

The management of the cross currency basis risk is a very big topic. In summary someone must look the mismatches within the bank and understand whether there is a reason that those exist and whether there is a way to reduce them. There are several ways of bringing down the risk from correctly forecasting the mix of currencies and the maturities in the asset profile to amending the contracts with clients in order to be able to pass the risk in some type of transactions.

What challenges and opportunities could financial institutions face when controlling and monitoring cross currency basis risk? How can they overcome the implications?

I would say that the data is as usual the key issue. But there are also other areas that a bank must develop in order to become more efficient. For example usually Treasury is the responsible function for funding the bank. That doesn’t relieve the responsibilities of the various businesses to understand how the funding works, how the cost is passed, what are the risks they run in case the funding risks increase etc. Communication is key.

Emerging Markets are even more interesting. We recently saw a very sudden and big in magnitude increase in the funding costs of Turkish Lira for the offshore banks. Understanding of the types of sources and uses, especially in emerging markets where volatility is much higher, is very important.

How do you see the impact of liquidity risk evolving over the next 6-12 months?

I think that the banks after the first wave of regulation where their main interest was to comply with the rules, they are now moving to a period that they try to improve the management and reduce the costs of that liquidity.