Basel III: Why the Liquidity Coverage Ratio is a Game Changer
Liquidity has been at the forefront over recent years, as many organisations faced financial difficulties despite their adequate capital levels and profitability. It was the management of their liquidity that put them under severe stress and eventually initiated central banks’ actions to support the financial system globally. Under the new regulatory regime, a strong LCR demonstrates a bank’s ability to absorb shocks deriving from financial and economic stress; it is therefore a critical measure of the financial strength of the institution and a strategic objective that drives the way the bank conducts business.
The introduction of the Basel III rules – and particularly the LCR standard – will inevitably lead to significant changes in the funding model of the banks. Financial institutions (FIs) will now not only focus on the quality of their assets but will also steer their reliance towards certain types of liabilities, to fund their balance sheet and ensure that the net cash outflows in a specified 30-day liquidity stress situation remain as low as possible. As a consequence, the dependency on capital markets funding will diminish in favour of wholesale funding.
As banks are expected to meet the LCR requirement continuously, they will need to ensure they maintain high quality assets and LCR-friendly deposits on their balance sheets. Focusing on the unsecured wholesale funding, the most attractive deposits are those generated by clients’ transactional activity, such as cash management and custody. These types of liabilities are expected to have a relatively low run-off factor in the above mentioned liquidity-stressed scenario and consequently be more valuable to the banks. However they will need to demonstrate to regulators that these balances classified as operational are directly linked to and required for their clients’ operational activities.
Establishing the Right Infrastructure
It is critical for the cash management providers to develop the right infrastructure that will enable their strategic institutional clients to form substantive dependency with them. In today’s fast paced environment, this is a rather challenging task because of the evolving and increasingly challenging corporate requirements. Corporates deploy their capital to extend their international presence in remote countries with certain cash management particularities but, at the same time, they strive to maintain global control and visibility. Liquidity optimisation, despite the historically low levels of major interest rates and operational efficiencies, also remains on the top of their strategic targets.
In order for a bank to provide an end-to-end solution that addresses all these challenges and eventually creates a structure to consolidate global transactional flows, it will require:
Powerful reporting tools are also essential to compliment even the most sophisticated treasury workstations and allow their users to make informed decisions.
On the liquidity optimisation front, longer maturities and higher stability will be treated more favourably and a premium for tenors longer than 30 days will be incorporated into investment solutions. As deposits with a remaining maturity of greater than a month will have a 0% run-off assumption, they will be considered more attractive for FIs.
Corporate treasuries with enhanced forecasting capabilities will be the first to take advantage of the new regime and be able to go longer on tenor and therefore even higher on the yield curve. On the other hand, corporates requiring assistance to forecast their liquidity flows and identify the longer term investable balances will rely on banks’ tools and an efficient structure to concentrate global balances and minimise or even eliminate intraday movements that typically generate fragmented positions and unpredicted overdrafts.
The regulatory changes will eventually impact clients in a positive manner. Banks will be looking at their cash management and custody relationships in a more holistic way and focus on end-to-end solutions that will generate efficiencies to their clients across all different areas of their cash management spectrum.
New products and services are developed around these principles. For example, deposit solutions on a rolling basis with maturities over 30 days that enable investors to achieve a competitive return even in historically low prevailing market rates and schemes that will allow clients to offset fees with non-interest deposits at preferential rates are becoming inseparable components of efficient liquidity arrangements. Integration and automation are important parameters to avoid operational inefficiencies.
Banks’ ability to package the individual components and structure a solution that will deliver benefits to both sides is the key to success going forward.