Funding

Let us go back to the breakdown of the previous section: r = risk-free rate + risk premium. The first term is public: it is the rate of the currency over the maturity concerned. The second is specific to each issuer: it is the price at which that particular bank manages to fund itself in that currency and at that maturity. It is called the funding.

Funding is not an abstract notion. A bank that issues a structured note borrows the investor's money, and pays for it at the rate at which it funds itself elsewhere: the bond market, deposits, repo.

The logic is that of the conventional bond market. An issuer rated BBB has to offer more attractive terms than an issuer rated AA− to raise the same funds, and the investor demands it. The same holds for a structured note: the higher the issuer's funding, the cheaper its zero-coupon bond, and the better the terms of the resulting product should be.

Same product, three issuers, three prices

Better terms are therefore explained in part by a weaker credit. Offers received have to be compared in the light of each issuer's risk. That holds for requests for quotes as much as for the investment decision itself. We will draw the consequences in 1.6.

Funding and CDS: close but not the same

When you want a sense of an issuer's funding without access to its treasury policy, you look at its CDS, the market price of protection against its default. It is the best public indicator available, and the two can be expected to move in the same direction. It would be a mistake, however, to believe them perfectly identical.

CDS stands for credit default swap. We will come back to this instrument in detail in the chapter devoted to credit products.

• What they share: the risk premium, the probability that the issuer will not repay. When the CDS widens, funding widens too.
• What sets them apart: their nature. Funding comes from an internal policy: what the bank is willing to pay to raise funds. The CDS is the risk as perceived by the market. The two are generally close, but they can diverge.
• A tactical lever: unlike the CDS, a market price that is simply taken as given, funding is a price posted by the treasury, which can adjust it as its needs require. A bank looking to raise funds will lift its funding to make its issues more attractive; a bank whose balance sheet is already liquid will lower it to slow the inflow. Generous funding therefore does not always signal a credit deterioration: it may simply signal a need for resource at a given moment.
• The rule on the ground: the CDS is there to measure moves, not to compute a price. It shows whether the perceived risk on the issuer has changed between the launch of the zero-coupon bond and today, and so helps make sense of the price moves observed.

Before and after Lehman: how it became a topic

Funding has not always held this place. Before 2008 a large bank was treated as near risk-free: every cash flow was discounted at the risk-free rate, and investors, wrongly, paid little attention to this factor.

The failure of Lehman put an end to that convention. Holders of structured notes discovered that they were creditors of a bank, including those holding a capital-guaranteed product. Counterparty risk and its compensation then became a genuine topic of discussion: investors began to differentiate between issuers, and funding took its place in the models as much as in the negotiations.

The secondary market showed it immediately. In late 2008, capital-guaranteed products from perfectly solvent issuers traded at discounts of several tens of percent, even as risk-free rates were falling, which should have pushed their prices up. The cause was the funding of those issuers, which had widened by several hundred basis points. A holder looking only at the yield curve could not make sense of the price of their products.

The following years embedded that change in the structure of the market, and funding emerged as an essential parameter in the pricing of structured products.