The aftermath of most disasters usually involves a raft of measures that aim to avoid or minimise the damage from any future similar disasters. When a devastating earthquake destroys entire towns, countries invest in improvements to early warning systems. Major floods in the Netherlands in 1953 resulted in the country’s construction of an elaborate flood prevention infrastructure. The Enron scandal resulted in the US introducing the Sarbanes-Oxley legislation.
The global financial crisis (GFC) of 2008-09 is no different. Regulators have enacted a wide variety of legislation, from Dodd-Franks and the European Market Infrastructure Regulation (EMIR) to Basel III, with the aim of averting similar financial crises in the future.
In particular, as part of the Basel III reforms, regulators have devised new rules for banks to measure and manage their liquidity risk, which can roughly be defined as the risk of running out of cash. The Basel Committee on Banking Supervision (BCBS) have introduced minimum limits for two key measures that financial institutions (FIs) globally will need to comply with in various phases between now and 2019. These limits could have a significant impact on their customers.
The first is the introduction of the liquidity coverage ratio (LCR), which is designed to improve banks’ short term liquidity coverage. The LCR is calculated as the bank’s amount of high quality liquid asset holdings divided by its expected cash outflows (including undrawn lending commitments) over a 30-day stressed scenario. Regulators want comfort that in the event of a run on a bank or another unexpected liquidity squeeze it will have enough cash and assets, which it can convert easily to cash to cover such a scenario.
The second measure is the monitoring of the net stable funding ratio (NSFR), which is designed to increase stable long-term balance sheet funding. This ratio has been formulated to encourage and incentivise banks to use stable sources to fund their activities and reduce their dependence on short-term wholesale funding. The rapid disappearance of this type of funding at the time of the GFC was a prime cause for the failure of several large institutions. To comply, FIs will need to ensure that their available amount of stable funding exceeds their required amount of stable funding over a 12 month horizon.
Figure 1: Basel III timeline
Proactive corporate treasurers should make two types of observations from these new rules for FIs and prepare accordingly.
In the first instance, it is important for corporates to consider the effects that this new regulation will have on the FIs they transact with. This will allow them to understand and prepare for the flow-on impact from these changes that banks will most likely pass on to their customers. From a liquidity perspective, the easiest way to appreciate this is in the context of the two liquidity ratios themselves.
For instance, an interesting behaviour already observed in Australia has been banks offering 31-day non-breakable deposits. This slight term extension then guarantees the liability doesn’t get counted in outflows over the next 30 days thereby boosting their LCR results. According to a Visual Risk survey, many FIs have already changed their pricing as a result of the new liquidity rules – or expect to do so within the next 12 months.
Similarly (although not discussed in this article) Basel III introduces new capital and other rules for banks. As a result of all these changes banks will think more carefully about how, what and to whom they lend, as well as the value, type and stability of deposits received. Corporate treasurers should engage now in discussions with their financial counterparts to ensure they will continue to offer the range of products the corporate may have been making use of. They should seek to understand what their ‘liquidity values’ are in the eyes of their bankers and investigate any potential changes to product pricing. Banks will welcome stable deposits and predictable liquidity. Companies should understand how their banks value their business and position themselves accordingly.
In the second instance, corporates should use this global focus on minimising the banking sector’s liquidity risk to consider their own liquidity risk policies, procedures and contingencies. Many companies already have existing measures in place and much progress has been made in improving liquidity management since the GFC.
However, for those not already robustly measuring their liquidity risk, it would be useful to devise corporate equivalent measures of the LCR and NSFR ratios. This would ensure companies’ short-term liquidity risk is covered by adequate funding facilities and their longer- term expected cashflows are well matched by future financing needs. Running a variety of stress scenarios and both measuring and reporting these against limits on a regular basis just like regulated FIs would represent best practice corporate liquidity management.
To accomplish this, corporates need to follow the efforts of FIs to invest in systems that both facilitate the regular collection of cashflow and position information and allow flexible cashflow forecasting for accurate liquidity risk management. System vendors have developed a variety of tools to help corporate treasurers better manage their liquidity risk. The key features are the ability to consolidate bank account balances, treasury flows and other company cashflows into a single system to flexibly forecast future liquidity requirements and, importantly, stress test potential liquidity shortfalls and overlay funding facilities.
The first step towards achieving this better management consists of gaining visibility over all bank account balances and liquid assets on an ongoing basis. Once this is accomplished, corporates need to import expected non-treasury cashflows and ensure their systems can easily forecast those future cashflows subject to financial market volatility, especially the possible performance of foreign exchange (FX) exposures and all derivatives.
With this infrastructure in place a corporate can set up equivalent measures to LCR and NSFR. For example it could divide the total of its cash and highly liquid assets, as well as secure emergency funding mechanisms such as overdrafts and working capital facilities by their stressed outflows of cash or capital over a short period (see Figure 2 below).
The corporate could apply similar risk weighted adjustments to these flows and thus maintain a liquidity position able to meet a crisis over a short period until other arrangements were put in place or could be accessed. Similarly, it should forecast its longer funding requirements against funding programs and capabilities to ensure future cash requirements are fully met by forecast cash inflows (see Figure 3 below for an example).
Figure 2: Example of a corporate-focused Short Term Liquidity Coverage Ratio (SLCR)
Figure 3: Example of a corporate-focused Medium Term Stable Funding Ratio (MSFR)
Corporates should report on these measures on a regular basis and also periodically conduct some disaster planning scenarios, whereby they use their systems to stress test their liquidity risk to ensure they are adequately prepared for adverse liquidity conditions in their business or the market.
These scenarios should include, for example, the failure of a lending institution, a squeeze in the market for funding such as that experienced during the GFC, and significantly different expected non-treasury or business flows, both in amounts and timing.
It’s clear that new Basel III liquidity regulations for FIs will impact corporate treasuries. Savvy company treasurers can use their risk experience to ensure they are well prepared for these changes and perhaps use advances in technology to lead the way in best practice liquidity risk management (LRM).
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