Measuring the Funding Costs of the Too Big to Fail Banks: The U.S. Dollar Cost of Funds Index™

The Need for an Objective Cost of Funds Index
On a typical day in the U.S. corporate bond market, there are significant bond trades in fewer than 20 of the 6,730 banks insured by the U.S. Federal Deposit Insurance Corporation. Moreover, there have been trades in only 14 U.S. banking legal entities in the credit default swap market since July 2010. That means for the overwhelming majority of financial institutions, an arm’ length benchmark for marginal funding costs is the only alternative since there is literally no trading in their own name. For many years, the interest rate swap curve was used as this benchmark for transfer pricing, asset and liability management, and internal probability assessment by the majority of large banks. With the unveiling of the Libor scandal and the associated prolonged period of negative interest rate swap spreads to the U.S. Treasury yield curve, the swap curve has lost credibility as a reliable benchmark for the marginal cost of funds.

For this reason, a new benchmark is needed that has these characteristics:

• It should realistically measure the marginal cost of new funds to the financial institutions with the largest trading volume.
• It should be based on public information that is readily verifiable by any investor or other market participant.
• It should be based on actual trades, not estimates of trading costs.
• It should be a calculation that can be done without the input of information or the cooperation of any of the financial institutions named in Libor-related lawsuits.
• It should be based on such a large volume of trades that manipulation of the benchmark would be difficult, if not impossible.
• It should be a composite of data relating to a number of financial institutions so that no one institution’s cost of funds is used as the benchmark.
• The calculation methodology should be transparent and replicatable by any third party.
• The calculation agent should not be a legal entity or other organization directly or indirectly controlled by the group of financial institutions named in Libor-related lawsuits.

The U.S. Dollar Cost of Funds Index^TM from Kamakura Corporation
Kamakura Corporation has created just such an index, labeled the “U.S. Dollar Cost of Funds Index.^TM” The U.S. Dollar Cost of Funds Index ^TM measures the trade-weighted cost of funds for the largest deposit-taking U.S. bank holding companies. The index is a credit spread, measured in percent and updated daily, over the matched maturity U.S. Treasury yield on the same day. The current bank holding companies used in determining the index are Bank of America Corporation (BAC), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM), and Wells Fargo & Company (WFC). The index is an independent market-based alternative to the Libor-swap curve that has traditionally been used by many banks as an estimate of their marginal cost of funds. Kamakura Corporation is the calculation agent, and the underlying bond price data is provided by TRACE and the U.S. Department of the Treasury. The National Association of Securities Dealers launched the TRACE ( Trade Reporting and Compliance Engine) in July 2002 in order to increase price transparency in the U.S. corporate debt market. The system captures information on secondary market transactions in publicly traded securities (investment grade, high yield and convertible corporate debt) representing all over-the-counter market activity in these bonds. For each of the reference names used in the calculation of the index, Kamakura Corporation assembles bond data as follows:

• All bond trades of that reference name are gathered from TRACE.
• All bonds which are not fixed rate debt issues are dropped.
• All bonds which are not “non-call” (other than “make whole” calls) are dropped
• All bonds which do not pay interest semi-annually are dropped.
• All “survivorship option” bonds are dropped.
• All bonds with a changing interest rate or principal amount tied to any index are dropped. This eliminates structured products.

The result is a large number of straight non-call fixed rate senior debt issues which traded that day. On August 8, 2014, a slow trading day on a Friday during prime summer vacation season, the number of trades underlying the index is given here:

After the cleansing process described above, there were 844 different trades in 122 bond issues with an underlying daily trading volume of $239.2 million. This contrasts with the Libor calculation procedure in which there are zero trades for $0 on 0 instruments. The four underlying institutions were the 3 ^rd, 4^th, 6^th and 17^th most heavily traded bond issuers on August 8, 2014.

Assembling the Composite Index
The composite credit spread is then calculated as follows:

1. The traded-weighted average yield is calculated for each of the underlying bonds.
2. The matched-maturity U.S. Treasury yield is interpolated from the “on the run”
3. maturities published by the U.S. Department of the Treasury.
4. The trade-weighted credit spread for each issue is calculated by subtracting the interpolated matched maturity Treasury yield from the trade-weighted average yield.
5. Since the spread varies by years to maturity, a curve is fit to all observable bonds using a cubic function of the years to maturity t on each issue.

Credit spread = a + bt + ct² + dt³

The coefficients a, b, c, and d are calculated using ordinary least squares regression on a trade-weighted basis.

The U.S. Dollar Cost of Funds Index is graphed here for August 8, 2014:

The terms, trading volume, and pricing for each underlying bond, the matched maturity U.S. Treasury yields, the coefficients of the index function for that day, and the “on the run” values of the index are provided by Kamakura Corporation to index clients.

Using the Cost of Funds Index
In the next installment of this series of notes, we use the U.S. Dollar Cost of Funds Index^TM to measure the funding advantage or disadvantage of a number of financial institutions versus the big 4 institutions currently underlying the index. For more information on the U.S. Dollar Cost of Funds Index^TM, please contact info@kamakuraco.com.