Lesson 22 of 25 · 6 min

Dealer balance sheets and the capacity to absorb

How much risk the system can hold is somebody else's internal limit, and it shrinks on a calendar.

Somebody has to hold an asset between the moment you sell it and the moment a final buyer appears. The size of that somebody is a hard ceiling on how fast anything can be sold, and it is a number rather than a disposition.

Intermediaries hold inventory against equity, subject to limits on total balance sheet relative to that equity. An illustrative firm with $260,000,000 of equity and a twenty-times limit can carry $5,200,000,000 of assets. That capacity is not spread evenly: low-margin uses, of which secured funding against liquid collateral is one, earn the least per unit of balance sheet and are the first to be cut when the constraint binds.

Some of the contraction runs on a calendar rather than on events. Balance sheet measured on a reporting date can be reduced by not holding things on that date, so capacity predictably thins around those dates and returns afterwards. A firm targeting seventeen times instead of twenty withdraws $780,000,000 — 15 percent of its capacity — in a week chosen by a reporting convention rather than by any market.

Two consequences reach a pledged portfolio. Short-term secured funding rates spike on those dates; an illustrative 154 basis point spike lasting three days, four times a year, works out at 154 times twelve divided by 360, or 5.13 basis points of annual funding cost, which on an $84,000,000 book is $43,120 a year and has to be recovered in a spread. And a decline that happens to land near a reporting date meets a market with 15 percent less absorption capacity, which raises the impact of every forced sale in it, including the one that cures somebody else's shortfall and marks down your collateral.

Key terms

Balance-sheet capacity: The total assets an intermediary may hold given its equity and its leverage limit. A ceiling on how much risk the system can warehouse.
Leverage limit: A cap on assets as a multiple of equity. Because it counts all assets equally, it presses hardest on the lowest-margin activities.
Reporting-date contraction: The predictable shrinking of intermediary balance sheets around measurement dates, and the equally predictable recovery just afterwards.

Worked example

Capacity that moves with the calendar

Illustrative figures. An intermediary with $260,000,000 of equity, a twenty-times limit ordinarily and a seventeen-times target across a reporting date.

Ordinary capacity: $5,200,000,000
Capacity across the reporting date: $4,420,000,000
Withdrawn: $780,000,000
Funding rate spike, three days, four times a year: 154 bp
Annualised cost of that spike: 5.13 bp
On an $84,000,000 funded book: $43,120 a year

Fifteen percent of the market's capacity to absorb a sale disappears on dates known a year in advance and unrelated to conditions.

Check yourself

An intermediary holds $145,000,000 of equity against a twenty-two times leverage limit, and targets 18.5 times across a reporting date. How much capacity is withdrawn, and why does it matter to a pledged portfolio?

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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.