Liquidity Risk Management: Making Pragmatic Improvements

During the recent financial crisis, liquidity in the international transaction system evaporated as a consequence of the complexity of interconnected systems, the difficulty in alignments of operational practices, and trust issues between financial institutions.

Politicians, central financial institutions and regulators had to restore liquidity in the financial system and take measures to avoid such a crisis from happening again. As a result, more regulation and much closer supervision will be the ‘new normal’ – and you will most likely have to invest to comply.

Some Problems Identified

First, let’s look at some of the problems that led to this result, in particular related to transactional liquidity risk:

Insufficient awareness of chain of events – solutions that minimise counterparty risk by not executing deals until the last minute reduce risk for one player but increase liquidity risk to the system and the other players who expect the money.

Siloed approach – in larger institutions, stopping outgoing payments to one particular counterparty requires co-ordination across several units and geographies – a manual process in most cases; few financial institutions run their payment and securities treasury under a common supervision, leading to a fragmented and poorly coordinated approach.

Insufficient information – in many cases only 60-70% of available funds are visible at any time, due to lack of appropriate organisation, reporting systems, but also insufficient or (too) infrequent information or reporting leading to an oversized liquidity buffer and to substantial overdraft or intra-day credit lines costs.

Insufficient transparency on detailed positions – accessing liquidity depends on the legal entity carrying the exposure (as opposed to group limits) and legislation of the geography this entity is incorporated in determines the terms and conditions of failure, and the claiming of assets.

Two Pragmatic Improvements

While liquidity risk must be tackled top down and calculated bottom up, there are two dimensions that underpin everything else and that you can address now:

1. Improve intra-day liquidity visibility, through better communication flows. To obtain and maintain a full, intra-day visibility on your liquidity risk position requires connecting up and gathering position and liquidity information from various internal systems, business lines and divisions within your financial institution. But you need to go beyond that. To get a true view on exposure, you need to link up branches and subsidiaries, as well as ensuring better communication flows with the ‘external world’ of account holding institutions and agents, systems and market infrastructures.
2. Improve liquidity forecasting capability, by building a transaction data warehouse. The timing of liquidity has increased in importance. Whereas positions were previously considered end-of-day, liquidity risk now needs to be managed intra-day, short term one week out, as well as determining longer term funding requirements, running liquidity stress tests and calculating forward exposure… simultaneously. Reports to management, board, and supervisor include data ranging from intra-day to a three-month perspective. To achieve this, you need to build a data warehouse of detailed and timed transactions, events and positions across your financial institution. This data can then feed a calculation engine, be used to generate scenarios and produce reports for decision-making.

SWIFT/gtnews Survey Results

To get a better picture as to where financial institutions are in terms of improving liquidity risk, and on these two dimensions in particular, SWIFT and gtnews ran a survey in March-April of 255 treasury and liquidity managers at financial institutions. The survey highlights are presented below.

Financial institutions are investing

This may not come as a surprise. Indeed, 79% confirm that they started a project in operational liquidity management, liquidity risk management and/or regulatory reporting. On the other hand, this implies that 21% have not yet started a project.

Figure 1: 79% of Respondents Have Started a Project

Source: SWIFT and gtnews

While there is a focus in 2010, investments span multiple years and carry beyond 2012.

Figure 2: Timing of Investments

Source: SWIFT and gtnews

Increased need for intra-day liquidity information

Financial institutions now have to demonstrate their ability to manage liquidity on an intra-day basis (in the UK as of October 2010). However, 90% of respondents do not seem to be ready yet, as they are still looking to collect more frequent and granular liquidity reports. A staggering 38% declare that less than 25% of transactions are reported on the same business day.

Building a global liquidity position

Many financial institutions have a decentralised nostro account management. It is a challenge for the treasurer to establish a global, firm-wide liquidity position. This explains why 68% are interested in directly receiving a copy of the nostro reports sent to their branches – rather than having to rely or wait for the branches to report this information into the central treasury.

Professional integration services to link it all together

With more liquidity information to be gathered from various systems including from branches, 58% are looking for external professional services to integrate it all.

Traffic data and business intelligence

There is an enormous need for more traffic flow data and business insights. Over 87% are looking for traffic monitoring and trend analysis, benchmarks and peer comparison and/or data in support of liquidity risk management (e.g. counterparty concentration).

Figure 3: Interest for Traffic Data and Business Intelligence

Source: SWIFT and gtnews

Investing in applications

A significant number of financial institutions are looking to acquire a new application or replace an internally developed solution: 55% would invest in liquidity management, liquidity risk management or regulatory reporting software.

Conclusion

Throughout the recent financial crisis, we all witnessed the specific and wicked nature of liquidity risk and its severe effect on banks, the global financial system, and the ‘real’ economy.

This article has focussed on pragmatic actions you can take to improve liquidity risk management now:

1. Improve intra-day liquidity visibility, through better communication flows.
2. Improve liquidity forecasting capability, by building a transaction data warehouse.

There is also a positive message of competitive opportunity. Banks that manage their liquidity well are thriving. A well-executed and fine-tuned liquidity strategy frees up precious capital that can be used to fund growth and new opportunities.

In addition to ‘putting your own house in order’, further industry collaboration is required – to evolve regulatory frameworks with legislators and improve and set up new infrastructure, products and crisis management in the banking industry. This discussion should be started now.