Case 016Counterparty risk and CVACore
A bank lends Rs 500 crore in repo against corporate bonds with a 10% haircut. The bonds fall 15% in a week, the borrower defaults, and selling costs another 5%. What does the bank lose, and how should the haircut have been set?
1The situation
Your bank lends Rs 500 crore to Solvira Capital, a leveraged credit fund, in a one-month repo. Solvira delivers corporate bonds as collateral, and the bank applies a 10% haircut, so it holds bonds worth Rs 555.6 crore.
Over the following week the bonds fall 15% as the credit market sells off. Solvira fails to meet its margin calls and defaults. The bank seizes the bonds and sells them into a weak market, where the bid it gets is a further 5% below the screen price. Ignore accrued repo interest.
2Your task
How much does the bank lose, and what haircut would have covered this outcome?
Quick check
Roughly how much does the bank lose?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The bank loses about Rs 51.4 crore. Its Rs 555.6 crore of bonds fell 15% to Rs 472.2 crore and fetched 5% less again, Rs 448.6 crore, against Rs 500 crore lent. A haircut must cover the worst likely price move over the time it takes to close out, plus the cost of selling; for this outcome that is about 19%, not 10%.
Step 1What is a haircut meant to protect against?
A pawnbroker who lends Rs 8,000 against a gold chain worth Rs 10,000 is not guessing. The Rs 2,000 gap has to cover gold falling before the chain can be sold, and the discount a buyer demands. A haircut is the lender's cushion for what can happen between the last time the borrower paid margin and the moment the collateral is turned into cash. That span is the margin period of riskThe time from the last successful margin payment until the lender has closed out the defaulted position, often several days to a couple of weeks., and the haircut must cover both the price move over it and the cost of selling.
Step 2How big is the loss?
Start from the collateral. A 10% haircut on Rs 500 crore means the bank holds Rs 500 crore divided by 0.9, Rs 555.56 crore of bonds. A 15% fall takes off Rs 83.3 crore, to Rs 472.2 crore, and a 5% discount on the sale takes off Rs 23.6 crore more, leaving Rs 448.6 crore to repay Rs 500 crore. The shortfall is Rs 51.4 crore, now an unsecured claim on a defaulted fund.
Step 3How should the haircut have been set?
Work backwards from the outcome you want to survive. The collateral must be worth at least Rs 500 crore after a 15% fall and a 5% sale cost. That needs Rs 500 crore divided by 0.85 times 0.95, Rs 619.2 crore of bonds, a haircut of about 19.2%. In practice the price move comes from the bonds' volatility over the margin period of risk at a high confidence level, and the sale cost from how much of the issue the bank would be dumping.
| Haircut | Bonds held | After 15% fall | After 5% sale cost | Shortfall |
|---|---|---|---|---|
| 10% | 555.6 | 472.2 | 448.6 | 51.4 |
| 19.2% | 619.2 | 526.3 | 500.0 | 0.0 |
Two further points separate a good answer. Solvira is a leveraged credit fund posting corporate bonds, so its ability to pay falls exactly when its collateral falls: that is wrong-way risk, and it argues for a larger haircut or different collateral. And the loss built up over a week, so ask why margin calls were not met and enforced daily. The limitation: a haircut sized for a 15% week is still exceeded by a worse week, and concentration in one issuer makes the sale cost larger than any screen suggests.
Where candidates lose it
Candidates compare the 10% haircut with the 15% fall and say the loss is 5% of the loan, forgetting that the haircut is taken on a larger collateral amount and that selling costs money too.
The second miss is setting the haircut from the price move alone. The cost of turning bonds into cash in a falling market is part of the loss and belongs in the haircut.
What the interviewer asks next
- Solvira had posted government bonds instead. How would the haircut and the loss change?
- What is wrong-way risk, and where else does it appear in a bank's book?
- The bank sells the bonds over two weeks instead of in one day. What does it gain and what does it risk?
Company names and figures are illustrative.