Where no market price is available or those that are available are judged to be unreliable – for example because they are out of date – the Bank calculates a model price to value a security, based on a standard bond pricing model of discounted expected future cash flows. The Bank uses its judgment to assess the validity of that model price, including by comparing it to similar traded securities where available, and drawing on any relevant market intelligence it has gathered from market participants. Haircuts The Bank’s haircuts are designed to reduce the likelihood that the Bank would incur a loss if forced to realise and liquidate collateral in the wake of a counterparty default. So the haircuts not only have to protect against the risk of counterparty default (credit risk), but also take account of the likely value of that collateral in stressed liquidity conditions (market risk). As a result, the Bank adopts a graded approach, with “base” haircuts varying by the type of collateral offered reflecting the different associated risk characteristics. It includes the likely correlation of risk e.g. that the value of a counterparty’s collateral will fall as the counterparty itself becomes stressed. Over and above those base haircuts, and where appropriate, the Bank imposes idiosyncratic haircut add-ons, based on both the type of collateral and the counterparty. In some cases, that reflects stress tests applied to the underlying assets.
That means that less conservative haircuts would sometimes be required to support a given level of borrowing. That will benefit counterparties as well as deliver risk management benefits to the Bank. The Bank will also require the data to be made available to investors and other market professionals, so that they will be able to undertake their own risk analysis. That should deliver longer-term benefit to the financial system as a whole – standardising, simplifying and publicising the data should all reduce the mechanical reliance on third party judgments and  8  The counterparty can meet the margin call by either providing more collateral, substituting some of the existing collateral with higher quality assets which receive a smaller haircut, or returning some of the lent funds. 9  The aim would be for the Bank’s risk tolerance to be broadly the same for loans as for a securitisation of those same loans, so as not to provide incentives to submit one form of collateral over the other. BIS central bankers’ speeches  7  models, and hence reduce “single points of failure” within the ABS market (although it will be up to market participants to make best use of these changes). Other policy issues on the agenda There are some big issues facing the Bank and its collateral management going forward. The immediate challenge is to wind down the SLS to its conclusion in January 2012.