Lesson 5 of 25 · 7 min
The funding chain behind a line, and the haircuts inside it
A second discount sits above yours, set by parties you will never meet, and it decides how much your lender can lend.
A line of credit is not funded out of a vault. It is funded by the lender borrowing, usually against collateral of its own, on terms set by somebody further up a chain.
The chain has at least three links. You pledge securities and draw cash. The lender funds that cash partly with its own capital and mostly by borrowing short term in secured markets, where it pledges securities and is charged a haircut of its own. The parties lending it that money are cash pools with their own rules about what they will accept and at what discount, and those rules are reviewed on the same kind of schedule your advance rate is.
Track 1 lesson 4 described a haircut from inside a single link: a discount sized to what the collateral could do during the window in which it is being sold. The chain is that same rule applied at every link, by parties with the same anxieties, keyed to the same volatility. The links are therefore not independent. The conditions that widen one widen all of them within days of each other.
book capacity = capital committed / wholesale haircut
- book capacity
- The total client borrowing the lender can fund with a fixed amount of its own money.
- capital committed
- The lender's own money set aside for this business. Slow to change and usually fixed in the short run.
- wholesale haircut
- The discount the lender's own funding counterparties apply to the collateral it pledges upstream.
The arithmetic is unforgiving because the haircut is in the denominator. A lender with $4,200,000 of capital committed to this book can support $105,000,000 of borrowing at a 4 percent wholesale haircut. At 7 percent it can support $60,000,000. Three points upstream removed $45,000,000 of capacity, a 42.9 percent cut, with nothing whatever happening to any borrower. That capacity has to come from somewhere, and downstream advance rates are where it comes from.
Key terms
- Funding chain
- The sequence of borrowings that stands behind a loan. Each link pledges collateral to the next and is charged its own discount.
- Secured funding
- Short-term borrowing collateralised by securities, rolled over continuously. The main way a lender finances what it lends.
- Wholesale haircut
- The discount applied to a lender's own pledged collateral by whoever funds it. Invisible to the borrower and decisive for the borrower's capacity.
Worked example
Three points upstream, forty-five million downstream
Illustrative figures. A lender has committed $4,200,000 of its own capital to a securities-backed lending book and funds the remainder in secured markets.
- Capacity at a 4 percent wholesale haircut
- $105,000,000
- Capital needed to carry an $84,000,000 book at 4 percent
- $3,360,000
- Capital needed to carry the same book at 7 percent
- $5,880,000
- Capacity at a 7 percent wholesale haircut
- $60,000,000
- Capacity removed
- $45,000,000
$4,200,000 / 0.04.
$84,000,000 x 0.04.
$84,000,000 x 0.07.
$4,200,000 / 0.07.
A 42.9 percent reduction.
The lender is now $1,680,000 of capital short of carrying the book it already has. Nothing it can do about that is visible to a borrower until an advance rate changes.
Check yourself
A lender commits $6,800,000 of capital to a book funded against a 3.5 percent wholesale haircut. The haircut is revised to 5.25 percent. What happens to the size of book it can support?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.