BankingRight Here, Right Now – How Important is Real-Time for the Banking Industry?

Right Here, Right Now - How Important is Real-Time for the Banking Industry?

Liquidity and risk management

Continuous link settlement (CLS) and real-time gross settlement systems (RTGS) systems have put pressure on banks’ liquidity and risk management practices.

CLS imposes timed pay-in and payout schedules, emphasising liquidity management as an interlinked, global issue. Designed to eliminate the risk that one counterpart in a foreign exchange trade will fail before both legs are settled, CLS enables the simultaneous exchange of value between settling parties — payment versus payment — introducing a far higher degree of certainty into the foreign exchange settlement process.

This occurs during a five-hour real time settlement window of the overlapping business hours of the participating RTGS systems, giving CLS settlement the same finality and certainty as a domestic RTGS or equivalent payment system. If the strict settlement criteria for both the payment instructions received into the CLS bank from the parties are not met, the instructions do not settle and no funds are exchanged, protecting the principal of both parties.

Delivery versus payment (DVP), whereby securities are transferred from the seller to the buyer at the same time that the final transfer of funds from the buyer to the seller is made, has also had an impact on liquidity and risk management. Both CLS and DVP rely on the simultaneous nature of settlement. They therefore require treasury managers to pay much more attention to the time on a particular day when a transaction needs to be settled, rather than the value date itself. Failure to make a payment represents not only financial risk, but also a risk to the reputation of the financial institution.

From May 2004, the US Federal Reserve will be open 22 hours a day. It is likely that other RTGS systems world-wide will follow suit.

Intraday liquidity charging

Costs associated with intraday liquidity policies will put pressure on treasuries to better manage liquidity.

The timed nature of settlement has thrown the spotlight on the provision of intraday liquidity as a service for which a charge can be made. Intraday liquidity requirements are funded by central bank money; banks therefore must have sufficient funds in their central bank accounts throughout the processing day.

There are costs associated with liquidity for individual banks, including direct funding costs, such as the interest paid and fees applied on central bank credit, the opportunity costs of maintaining funds in central bank accounts and the cost of tying up collateral or securities in order to obtain central bank credit.

Most industry observers believe intraday liquidity will become a traded commodity. The US Federal Reserve charges for liquidity by the minute, while in Europe the central banks require collateral, which implies a cost of carry by the day. It is expected that CLS may act as the catalyst for the creation of an intraday liquidity market.

There is an argument that liquidity has always attracted a charge and what is now happening is that participants are beginning to break down the components of an overall service. Liquidity was previously included and charged for within that fee. With a general trend towards transparency of pricing, liquidity charges are now being extracted as a separate component.

Basel II Accord

Basel II and its focus on operational risk will have an impact on cash management.

Under the Basel II Capital Adequacy Directive, slated to become mandatory by the end of 2006, banks will have to demonstrate a three-year track record to regulators that they can manage their payments and liquidity under these new real time regimes. The intention of the Basle II Accord is to foster a strong emphasis on risk management and to encourage ongoing improvements in banks’ risk assessment capabilities.

The Basel Committee believes improvements can be gained by closely aligning banks’ capital requirements with prevailing risk management practices and by ensuring that this emphasis on risk makes its way into supervisory practices and into market discipline through improved disclosure of risk and capital.

The Accord explicitly covers only two types of risks in the definition of risk-weighted assets – credit risk and market risk. Other risks, such as operational risk, are presumed to be covered through the treatments of the two main risks.

Three different approaches to calculate capital requirements are recommended by Basel II, taking into account that a “one size fits all “ strategy is inappropriate. The internal ratings based approach uses banks’ internal assessments of key risk drivers as the primary input for capital calculation. The IRB approach does not allow banks themselves to determine all of the elements needed to calculate their own capital requirements.

Instead, the risk weights and thus capital charges are determined through the combination of quantitative inputs provided by banks and formulas specified by the Basle Committee. An internal rating system is only as good as its inputs, says the Committee. Banks will be expected to have in place a process that enables them to collect, to store and to utilise loss statistics over time in a reliable manner.

Competition

The clearing business of banks is becoming much more competitive and real time information delivery is likely to play a more important role in winning mandates.

Correspondent banking is undergoing significant changes, wrought by industry-wide initiatives and regulatory pressures to eliminate risks in the payments and settlement system. The clearing business of banks is a hard-won, highly competitive area and is subject to formal tends for business, rather than relationship banking.

While there are significant challenges for banks, there are also opportunities to attract more business. Once an industry based on relationships, correspondent banking is likely to become much more competitive in the future.

Banks have been delivering real time information to their correspondents and corporates for some time. However, as all parties look to improve efficiency and increase straight through processing rates, a way to standardise the delivery of real time information is required. Hazlewood points up that this will help banks to deliver information to clients on a consolidated basis, for all of their account structures.

This could lead to a rationalisation of account structures, enabling them to be managed more efficiently. Real time information will enable clients to move funds to the right place at the right time. The ability to give clients information on their positions and how they can be consolidated is at the heart of treasury management. Banks that can provide that information to their clients, on a real time basis, will be in a position to retain that relationship and enable it to grow.

John Hazlewood, Vice President, Product Management Executive EMEA, JP Morgan Treasury Services, said: “The message that we receive from both financial institutions and corporate clients every day is: show me something that’s going to reduce costs, going to bring some additional value to enable me to improve the way I go about my own business.”

Legacy systems

Legacy systems are not equipped to deal with real-time information and are based on batch processes.

The legacy back office systems in most financial institutions do not manage timed payments successfully. Nor does the technology enable banks to access realtime information on balances, transactions and liquidity positions during the course of the business day as required by RTGS systems.

The infrastructure used by banks has been developed over a number of years. In many cases, the systems and technology that is used is quite old.

Richard Pattinson, Senior Director of Settlement Strategy and Systemic Risk at Barclays Bank said: “I wanted real time information in my varied Nostro accounts where I wasn’t clearing for myself. I wanted to bring it on to a single platform because I had moved out of managing liquidity in silos to managing it globally in a multicurrency environment.”

Why use real-time information?

Real-time information has the potential to improve a number of areas, including reconciliation, funding and position keeping, and customer service.

While many banks have not yet implemented the real time IP-based SWIFTNet network, SWIFT is working with a group of banks to investigate the benefits of realtime information.

For example, reconciliation is one area that will greatly benefit from the application of real-time information. At present, the reconciliation process is done after the event, and can take an average of three days. However, in reconciling payments, banks will have to track through thousands of items to find those that are wrong. The more an institution can reconcile in real time, the faster it can get to the items that have failed to reconcile.

Those institutions running a 24-hour shop can find errors in real time and resolve them within the settlement day. This has the potential to considerably shorten the duration of any loss suffered.

In terms of funding and position keeping, if treasurers can base their calculations on the precise details of where funds are flowing, rather that the present guesswork based on historical information, positions can be managed much more accurately.

Eric Sepkes, Director of Cash Strategy, EMEA Citigroup noted: “The function of funding and position keeping is doing exactly the same before the event as after the event, so why not merge the two functions together? You suddenly think: wow, I have just changed an awful lot here.”

The role of application vendors

Application vendors need to develop systems that can accommodate real-time information feeds.

As users see the benefit, and as they understand how real-time information can be used in the back office and other operational areas of banks, there should be a greater take up of real-time information.

It is vital that application vendors react to financial institutions’ needs. Banks will grapple with a number of issues in order to prepare themselves for real-time information. For example, how can systems be adapted to process and digest real-time information automatically? Account structures must be rationalised and banks need to consider how any changes are position in the context of risk management practices.

Around 90% of banks run batch legacy systems. If realtime data is delivered to those batch systems, it is more than likely that the information will be fed back into batch systems, with no benefits.

It is up to software vendors to embrace the real time world and to deliver middleware and other applications that will allow banks with legacy systems to get the benefits of real-time data.

This in turn will make possible the operational integration of exception management with the money desk in Treasury to generate improved efficiencies and cost savings.

Quantifiable benefits of real-time information

Most observers believe that the move to real-time information will be slow. However, there are immediate benefits that can be reaped by institutions that choose to adopt real-time applications now.

One of the first applications to take advantage of realtime information is Cable & Wireless Real Time Nostro. It is an IP-based service that enables browser access to consolidated real-time or near-real-time multi-bank account information. This information is extracted from internal systems by the providing bank and delivered to an external central ‘hub’. Subscribers receive data via secure connection either via a browser to desktops, via SWIFTNet or via an application programme interface (API) to internal systems that utilise and extract value from the information contained.

By making more useful information available on a continuous basis to the relevant functions within a bank’s operating environment, financial institutions would be well positioned to undertake a level of operational reengineering to occur amongst its internal structure and processes.

This would enable banks to move away from their traditional, clerically-entrenched operations to an enhanced day-of-settlement approach. These reduced back- and middle-office functions should offer more opportunity to focus on external and customer-related developments and offer the potential to reduce costs by 20% to 50%, while still retaining its ability to absorb growth.

A call to action

Regulatory and cost pressures are driving the financial industry inevitably towards real-time environments. A move from batch-based to realtime processing will not be easy; it is therefore up to all participants – banks, corporates, application vendors and network operators – to consider the steps they need to take to operate in a real-time environment.

Vendors of reconciliation systems, middleware and reporting systems need to understand how their applications should be adopted to accommodate real-time information feeds. Correspondent banks must investigate how best to re-engineer their operations to take advantage of the new way of working.

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