Just days before it was nationalised in 2008, one leading financial institution had a total capital adequacy ratio of 14.4%, nearly double the 8% required by the UK’s Financial Services Authority (FSA), and well in line with Basel II guidelines. Yet, despite exceeding the existing liquidity guidance, the institution failed. There have been many other notable organisations that have succumbed to the same plight.
We now know that in times of stress, complying with capital adequacy standards does not always ensure the successful management of liquidity risk. Liquidity risk can be defined as the risk arising when an institution is unable to raise enough cash to fund its business activities (funding liquidity), or is unable to execute a transaction at the prevailing market prices due to a temporary lack of appetite for the transaction by other market players (trading liquidity). Managing liquidity risk has become the key to financial institution survival.
The disappearance of active markets for complex structured assets, apart from government securities offered by rated sovereigns, underscores the fact that prices for those assets have become unreliable. The breakdown in the interbank funding markets and the virtual meltdown of term debt funding markets, for even highly rated financial institutions, also puts a strain on liquidity.
The deterioration in markets has shown us how easily and quickly institutional liquidity can evaporate. The credit crisis coupled with illiquid financial markets has made it extremely difficult for financial institutions to find credible alternative funding sources, successfully turn over their debts, and reduce maturity imbalances. In this environment, it is an ongoing struggle for many banks to manage and maintain adequate liquidity.
As a result, significantly greater amounts of liquidity support have been required of institutions by the central banks to sustain the financial system. Despite such extensive support, banks continue to fail, be forced into mergers or require resolution.
Rising Interest in Intraday Liquidity
Larger organisations, which have particularly complex and fluid balance sheets, have taken measures to build buffers and insulate themselves from external forces by accumulating large reserves, switching to long-term and domestic currency borrowing, and reducing fiscal and current account deficits. This safety net comes at the price of lost potential business. By limiting their risk exposure and taking a more conservative position, they trade off the inherent opportunities for new investments or transactions that fluctuating economic and financial conditions can create.
Revised regulatory guidelines have now cast a spotlight on liquidity risk and all related promulgations promote understanding, monitoring and managing liquidity risk very closely. Expressions like ‘near-term’ and ‘real-term’ have entered the lexicon of liquidity risk management. As a result, interest has increased in the market (particularly with the larger institutions) and among regulators in intraday liquidity management.
The goal of intraday liquidity management is to ensure that the organisation has adequate liquidity to raise the cash to fund its activities and execute transactions at prevalent market prices any time during the day. This is to prevent settlement problems caused by waiting until the close of business to process transactions.
Liquidity has become even more complicated to manage and regulate due to a widening structure of putative sources of both securitised and non-securitised forms of liquidity. There is also a forced reliance on marketable liquid assets coupled with traditional sources of liquidity through funding access. These factors challenge regulators’ ability to structure logical liquidity regulation, in that requirements can’t be based on one or only a few standard ratios, as is the capital adequacy ratio used to regulate solvency.
Further complicating intraday liquidity management, and indeed liquidity management in general, is the use of disparate systems to track liquidity sources and liquid assets – systems that are limited to end of day settlement. Maintaining the requisite interfaces and aggregating data to provide point-in-time information is expensive.
An important question arises: How will the additional costs incurred to create an intraday liquidity management environment be paid? There is no one answer, no silver bullet.
Increased liquidity management costs produce interest rates less favourable to long-term investment. Corporate customers alone cannot handle the costs (passed to them via higher fees or rates); they may refuse to accept them by taking their business to a competitor with more attractive rates, or they may abandon the transaction (and the activities it funds) all together. This would have a domino effect, impacting the broader economic picture. The greater the aggregate degree of such costs, the more systemic risks they generate in these troubled times.
On the other hand, assessing a capital charge on liquidity may not account for the interdependencies of various risk types. Liquidity risk does not occur in a vacuum, and allocating liquidity-related expenses equitably is very difficult. Banks should also consider other means to increase internal efficiencies and/or raise profitability to offset these costs.
Finding a More Sensible Approach
The increased stress brought about by the financial crisis should cause us to pause and reconsider liquidity measurement and modelling. In the same bank, at different times, similar liquidity positions may be adequate or inadequate depending upon anticipated or unexpected funding needs. Likewise, a liquidity position adequate for one bank may be inadequate for another.
Determining a bank’s liquidity adequacy requires an analysis of the current liquidity position, present and anticipated asset quality, present and future earnings capacity, historical funding requirements, anticipated future funding needs and options for reducing funding needs or obtaining additional funds.
Financial institutions must undertake a more searching examination of their balance sheet structures and decompose their balance sheet into contractual, and more importantly, behavioural cash flow buckets. Most retail lending and funding organisations have to examine customer behaviour to understand mortgage and non-determinant maturity cash flows. Without a good understanding of customer behaviour analytics, any structure of liquidity will be inadequate. This is especially true for managing intraday liquidity.
Developing Liquidity Scenarios
Building and implementing liquidity scenarios can facilitate daily stress testing. Results from stress tests should be analysed over 60-90 day periods because liquidity crises are rarely long-term. The scenarios should establish clear action guidelines to invoke a liquidity contingency plan and daily testing and analysis should help ensure that the plan has not become outdated.
The impact of shrinking liquidity illustrated in the following graphic indicates that all risks have a direct and tangible bearing on liquidity. If an organisation manages liquidity well, it is essentially managing and safeguarding its survival.
Regardless of the method or combination of methods chosen to manage a bank’s liquidity position, it is of key importance that institutions formulate a policy and implement a monitoring system with all of the tools to ensure that liquidity needs are established and met on an ongoing basis. A good policy generally provides for forward planning which takes into account the unique characteristics of the bank, management goals regarding asset and liability mix, desired earnings, and margins necessary to achieve desired earnings.
Planning should also take into account anticipated funding needs and the means available to meet those needs. The policy should establish responsibility for liquidity and funds management decisions and leverage technology to provide co-ordination among the different departments of the bank.
At least once every six months, the financial institution should review the results of simulation tests conducted, training provided and other activities undertaken to strengthen its ability to carry out the contingency plan successfully. The bank should regularly provide its Asset Liability Committee (ALCO) with a general assessment of the bank’s overall preparedness to address a possible serious funding problem before a crisis ensues.
The future of financial institutions will continue to be fraught with challenges, and in these troubled times, survival requires more than regulatory compliance. Instead, organisations should be relentless in actively managing all key risk areas, especially liquidity. The most reliable way forward is to seek and leverage multiple risk management perspectives for better self-regulation and real time management of all sources of intraday funding and the entire spectrum of liquid assets.
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