Flows across and between banks, information-, data- or cash-wise, are central to the operation of the financial system and, as part of this, of liquidity and funding management. The speed at which negative events continue to unfold adds a day-by-day, or in some cases, an intra-day time dimension to these dynamics. Intra-day liquidity and funding management is a core theme of the new Financial Services Authority (FSA) liquidity regime in the UK that seeks, inter alia, to embed intra-day (cash) exposure into the heart of banks’ stress testing and pre-emptive liquidity monitoring. The alternative is painful sanction exercised through inflated but under-performing liquid asset buffers, imposed by the UK regulator.
Banking and the State
The extent of inter-dependency between banks themselves and between the industry and the state has been well documented.1 Exalted as a force for good during the famed period of ‘irrational exuberance’, funding the new paradigm of seemingly riskless origination and distribution, this relationship has become vilified in equal measure as one of the root causes of a banking crisis that has damaged the balance sheet of the state.
The extent of state support for the UK banking system, for example, has eclipsed that of all previous financial crises, at close to three-quarters of the nation’s GDP (when accounting for both central bank and government support packages).2 The balance sheet of the Bank of England, the banker of the UK state, has swelled to a size not seen since World War 2, with little as yet discernible reduction in moral hazard. In their efforts to re-balance these terms of the social contract that exists between the banks and the state, the UK government (in common with governments across the world) is exposed to another irony; the same capital markets that fanned the financial tsunami are now judging the rear-guard efforts to mop it up. And it seems they are looking on with a very critical eye. No wonder the imposition of a bank levy is a shoe-in.3
Within the banking industry, the extent of inter-connection (and the extremes this produces in good and bad times) is marked in the area of liquidity; the access to funds that allows financial institutions to keep the wheels turning on their day-to-day operations. The implicit expectation that banks will be able to fund their payment and settlement obligations, in extremis, on an hour-by-hour basis, are only fully appreciated when it explicitly disappears. The 2007-09 crisis is characterised by the precipitous decline and in some cases collapse of formerly well-established companies, stark reminders that counterparty risk does materialise without warning. The funding taps really did turn off between one day and the next (or for those trading east to west across the world, within a single day).
The dimension of intra-day liquidity is a key component behind the efforts of the UK regulator to shore up the management of capital and liquidity risk (and thereby redress, to some extent, the imbalance in the social contract). These are rightly placed in the lexicon of sound banking practice4 – that liquidity management should ensure that assets are funded with liabilities of similar tenor/maturity profile, that there should be no over-reliance on short-term wholesale funding sources, that liquid assets should be safeguarded for use in an emergency, that access to Central Bank facility should be secured where possible, and that internal transfer pricing should be set correctly for the risks incurred, inter alia.
For business made up of (static) books with long dated and illiquid assets these ideals may be readily achievable. However, for activity that is short-term and frequently traded, its funding follows the same path given the shortfalls, mismatches and behavioural oddities that will inevitably occur. The ebb and flow of intra-day and overnight cash is the preserve of the traditional cash management and funding projection function within banks that, like other functional areas beyond mainstream treasury asset liability management (ALM), are being scrutinised for their role in promoting sound liquidity management across an organisation.
The New UK Liquidity Regime
The immediate regulatory context is the FSA’s prescriptions on liquidity that have come into force this year. Grounded in the principles outlined by the Bank for International Settlement’s Basel Committee in 2008,5 and fore-running similar regulations being introduced across the global banking system, the new FSA rules look to penalise firms running sub-standard liquidity regimes with the requirement to hold a buffer of liquid assets that safeguards against a liquidity crunch.
The size and composition of the buffer will be determined by an evaluation of a firm’s liquidity adequacy, itself a function of its management of liquidity (scrutinising policies and processes controlling areas such as stress testing, internal funds transfer pricing, collateral management, its funding sources and access to contingency funding, its governance structure, and notably, intra-day cash management and funding, inter alia). The mechanisms employed within specific departments of organisations will therefore have a direct bearing on the organisation’s liquidity ‘rating’ as a whole. The greater the inadequacy of the liquidity management regime, the larger the size of the liquid assets buffer to be held in low yielding, safe investments. At a time when yield is being chased again to repair damaged balance sheets, that delta will be damaging to a bank’s bottom line.
Specifically, the testing of a firm’s balance sheet, comprising asset and liability cash flows, modelled under a number of stress scenarios, is at the heart of the evaluation being conducted by the FSA. Quantifying this behaviour, typically projected from one day out to a time series of six months-plus requires analysis techniques that are rigorous but widely understood. The UK regulator is therefore quite prescriptive in what it wants banks to model as stress.
Understanding one’s liquidity exposure within a single day (i.e. day zero) however, resulting from payment and/or settlement system disruption (the collapse of central matching counterparties, Euroclear and Clearstream for example), is less well established. This could be caused by the withdrawal of intra-day credit lines, marked increases in initial and variation margin requirements and/ or a spike in demand for pre-funding collateral (by agent or correspondent banks), for example.
Fails and Funding Exposure
Ordinarily the preserve of a day-to-day dialogue between treasury operations and the money market and funding desk, in order to keep external cash accounts as flat as possible, an intra-day liquidity crunch suddenly propels treasury into a search for excess billions of funding in order to honour its daily payment and settlement obligations. And this will be in an environment of deteriorating ratings, depositor withdrawals, widening credit spreads, and inter-entity contagion that characterise such a crunch. Explicitly targeted by the UK regulator in its liquidity regulations, banks have had to find a way to quantify intra-day exposure, reflective of a realistic set of behavioural assumptions.
There can be no uniform response to this requirement, itself a function of the type of business the firm is engaged in, but nevertheless the central assumption that payments follow receipts in an orderly queue around the world has to be ripped up. Essentially, firms have to assume that receipts of cash, generated from the settlement of trading activity or the interest on a bank loan for example, will be delayed. The delay could be the result of a deliberate strategy by a market counterparty to withhold outward payments (for fear of not getting back a similar sized sum from another reciprocal transaction), an unanticipated, operational error resulting in a failed transaction, or in extremis, a firm-specific collapse on the scale of Lehman Brothers. Foreign exchange (FX) trading presents an interesting flavour to this dilemma for the back office, in stress. An FX transaction in currencies in an eastern time zone (to the Greenwich meridian, such as Japanese yen) and in the west (e.g. Canadian dollar), under delayed (or ‘safe’) settlement whereby you only receive cash to fund the outward trade when your inward counterpart has received their cash to pay you, forces a decision: pay the Canadian dollar early by a day (without the Japanese yen), or pay the Canadian dollar late by a day (with the Japanese yen duly received but to the financial detriment of the onward counterpart’s counterpart, and so on). And then attempt to square that position with the front office!
Profiling cash flows in this way, for the global markets banks operate in, under normal and abnormal conditions, requires additional transparency to the already voluminous suite of liquidity MIS produced for management consumption. And this places significant demand on internal systems, and the supporting processes, to control these cash movements that can run to many hundreds of thousands per day. No wonder the regulator estimates the cost of complying with the liquidity regulations at between £3m and £7m for a full scope investment firm.6
The banking industry is a web of complex inter-dependencies and relationships that requires both an implicit and explicit understanding that obligations (whether cash-, information-, and/ or data-wise) will be met. When that understanding is challenged, the functioning of the whole banking system is threatened. Liquidity risk cuts to the heart of this, not just in an assessment of a bank’s forward (i.e. projected) cash position but the picture established on immediate, intra-day (i.e. within the day) lines. And the relationships across the industry are synonymous with those within the banks themselves, that need to unify all parts of a bank’s organisation around liquidity management, front to back.
1 Banking on the State: paper by Andrew G Haldane, Piergiorgio Alessandri based on a presentation delivered at the Federal Reserve Bank of Chicago twelfth annual International Banking Conference on ‘The International Financial Crisis: Have the Rules of Finance Changed?” Chicago, 25 September 2009.
2 Bank of England Financial Stability Report, June 2009 in Haldane and Alessandri, op cit.
3 And confirmed in the UK Government’s emergency budget of 22 June 2010.
4 Europe Arab Bank Treasury Market Comment Volume 1, Number 41, 13 November 2009.
5 Bank for International Settlements: Basel Committee on Banking Supervision ‘Liquidity Risk: Management and Supervisory Challenges’, February 2008.
6 Section 7, Pg 33 FSA CP 09/13 ‘Strengthening Liquidity Standards 2: Liquidity Reporting’ (April 2009).
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