By Mariusz Podsiadlo - Head of Product Management, Misys Global Risk – Liquidity
The aftermath of the credit crisis has seen a flurry of regulatory activity, especially in the previously ignored area of liquidity risk: the Basel Committee on Banking Supervision published its ‘Principles for Sound Liquidity Risk Management and Supervision’ in 2008 and the UK’s Financial Services Authority (FSA) significantly extended its liquidity regulatory regime, being the first regulator to propose the new liquidity reporting framework in 2009. The initial industry’s response to the relevant regulatory proposals was inherently skeptical and perceived them as onerous, unnecessarily detailed and impossible to deliver in the given timeframes.
Yet, the required work has been delivered:
- Capital and liquidity reserves are improving to the levels required by regulators (see the results of the Basel Committee's Basel III monitoring exercise).
- The picture of bank’s obligations over time can be created with daily frequency, allowing a better short- and mid-term utilisation of assets.
- Banks have scaled down their risk appetite and are more conscious of its cost.
- The improved data quality generated significant cost savings and put liquidity management high on the agenda. One study reports that during the FSA compliance project in a large UK bank, US$18bn worth of unused collateral (costing around US$35-US$50m per annum in terms of the potential liquidity cost reduction) had been ‘found’.
- Principals for sound liquidity management, as proposed by the Basel Committee in 2008, are now a recognised part of the standard risk management framework.
Still, the risk connected to the intraday liquidity usage (intraday payment risk and collateral requirements) has not been addressed. This applies to mid-size and large banks everywhere and its efficient management can provide similar benefits:
- Better monitoring of the double duty usage of the liquidity buffer, which heavy reliance upon was one of the reasons for Lehman Brothers demise (see the Bank of England Financial Stability Paper No 11).
- Significant cost savings – cost of cash and collateral reserved for clearing and settlement is substantial and will increase. It is costly and thus any possibility to reduce it provides a savings incentive. For example, a large UK bank may have to reserve US$1bn-$5bn worth of assets to support clearing and settlement of its daily sterling denominated activities. It is even more for multi-currency operations. In addition, a liquidity buffer is being introduced and the clearing rules are being scrutinised by Basel’s Committee on Payment and Settlement Systems (CPSS), making the reserved asset pile even bigger.
- Potential new opportunities – single holistic view of all intraday cash flows is increasingly valuable to bank customers, both internal and external. The behavioural analysis allows prediction and further optimisation of payment schedulers and collateral usage.
Consequently, regulators want to see a more active supervision of settlement buffers and intraday cash flows. The Basel Committee therefore published a related consultative paper, ‘Monitoring Indicators for Intraday Liquidity Management’, in July. The banks would have to report their daily liquidity usage pattern, demonstrate their ability to execute time critical settlement operations (e.g. CLS), resolve any intraday settlement errors and stress test the default event of a major customer (liquidity provider/consumer) or a currency nostro agent. The intraday liquidity indicators proposed by the Basel Committee are trying to provide the required behavioural information.
Now, the Basel Committee has published initial replies from the industry and other interested parties to its proposal. In general, the responses see the proposed measures as onerous, partially unnecessary and technically difficult to implement. This sounds familiar, recalling the perception of the FSA liquidity regime at the time of its introduction. But nowadays, large UK banks benefit from the improved data quality and holistic view of their portfolio’s liquidity (see above for the US$35m pa savings), delivered thanks to the FSA framework: FSA reports are also often used as the basis for their internal liquidity reporting set.
A similar pattern can be seen in the intraday liquidity reporting case: the requirements are onerous, need refining and the amount of work required is not to be underestimated but the technology is there to deliver, like in 2010.
Banks, which have already invested in multi-currency, real-time enabled liquidity risk management systems benefit from the functionality, delivering a good foundation for the increased scrutiny imposed by the incoming intraday liquidity regulations and having the ability to:
- Monitor and tune collateral usage and availability intraday, including the double duty role of the liquidity buffer.
- Monitor concentration risk exposure to key counterparties for cash and collateral obligations and inflows in all traded currencies at multiple times during the day.
- Forecast intraday cash flow timing and project the liquidity demand and risk exposure due to possible funding disruptions.
- Optimise the payment schedule based on historical intraday payment patterns.
- Control and prioritise timing of intraday payments.
- Flag and resolve any failed payments.
- Report on liquidity usage and its cost per customer and business unit.
The regulatory proposal may be updated but the bottom line remains: the ability to have a holistic analytical view of intraday and multi-day liquidity flow schedules delivers a competitive advantage and is high on regulatory agenda, moving towards being a legal requirement.