Liquidity risk management practices discussed

Representatives from Calypso Technology and Deloitte discussed Basel 3 and liquidity risk management in Asia Pacific during a live webinar, hosted by SCI in December (view the webinar here). Topics included the impact of the LCR and NSFR on banks, as well as how to align strategy with compliance. This Q&A article highlights some of the main talking points from the session.

Q: What are the main sources of liquidity risk that Basel 3 is designed to address?
David Little, director of strategy and business development, Calypso Technology: The liquidity risk that Basel 3 addresses is the one that was most prominent during the financial crisis: the risk of wholesale funding sources drying up. Many business models were predicated on funding being permanently available at very short notice, but those funding avenues dried up during the crisis.

What regulators are trying to achieve with Basel 3 is to strengthen the controls and resilience that financial institutions have with regard to potential future liquidity crises. To this end, the Basel Committee has introduced two measures - the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR).

The LCR is a short-term measure, spanning a 30-day horizon. It measures net cash outflow under severe stress scenarios and requires banks to hold enough high quality liquid assets (HQLA) to enable them to go to the central bank or other funding source to keep themselves operational for a minimum of 30 days.

The NSFR is a longer-term measure that requires funding between assets and liabilities to be matched over a one-year time horizon.

Q: What is the impact of the LCR and NSFR likely to be on banks?
Alec Kourloukov, director, risk consulting at Deloitte Enterprise Risk Services: Depending on the sophistication of a financial institution's infrastructure and the availability of data, the LCR and NSFR can become key risk indicators. Both ratios have predictive power because they draw lots of information from core banking systems, especially transaction systems related to cash inflows and outflows.

The LCR is a simple ratio measuring a bank's stock of HQLA over net cash outflows. These cash outflows have to be modelled under acute scenarios; for example, a three-notch downgrade or a partial run on deposits.

The definition of HQLA is specific and categorised into Level 1 and Level 2 assets. Level 1 assets are defined as central bank reserves, marketable securities issued by sovereigns that are traded in a deep market and so on.

However, this is a difficult definition to meet - especially from a Southeast Asian perspective, because the market may not be deep enough. For example, the Singapore government doesn't run a deficit and so there is a limited pool of government securities to choose from in that jurisdiction. If, therefore, you invest in Philippine or Malaysian sovereign debt, you need a clear assessment of whether that market is considered to be deep enough and whether such a move drives an institution to take new risks - such as country and political risk - as well as a potential increase in foreign currency exposure.

Level 2 assets include government bonds and double-A plus rated corporate bonds. Again, there are strict definitions around availability, and there may not always be the requisite market depth or volume of readily available assets.

Given the assets have to be high quality, the yields are relatively low, so there is a direct impact on bank profitability.

The NSFR ratio remains under discussion, since the implementation isn't until 2018. The measure is designed to promote medium- to long-term funding stability and reduce incentives for short-term wholesale funding.

It is defined as the amount of available stable funding over the required amount of stable funding over a one-year horizon. The available amount equates to the carry value of funding times a given adjustment factor.

Tier 1 and 2 capital, preferred stock, retail deposits and secured and unsecured borrowings can be included as available stable funding assets. Cash, money market instruments, loans and gold and so on can be included as required stable funding assets.

There is a stress-testing component to the NSFR, which will inevitably become an important part of the liquidity management framework. The idea is to strengthen liquidity management frameworks to make them more robust and advanced to meet the rapidly changing funding environment. But stress testing is another area where further guidance is needed.

Q: How should intraday stress testing be undertaken following the latest BIS consultative document?
Little: There is not much detail in the paper about exactly how the stress tests should be conducted, or how severe the stress should be. There is recognition that different stresses will be applicable to different banks, so I assume that there will be a significant amount of interpretation by each regulator and significant differences from bank to bank.

The consultation paper has attracted a lot of comments, many of them publicly available on the BIS website. But it is only a consultative document and we await the final paper.

Q: How should banks conduct the scenario analyses necessary under the LCR and NSFR?
Little: Because the traditional ALM function has a cash-oriented view of the world, it's proving difficult to undertake these calculations. Liquidity stress ratios require scenarios where business is projected forward to gauge what may happen to future cashflow under stressed scenarios.

To do this, you need to be able to model and price real transactions that are underlying those cashflows. Traditional ALM solutions don't typically have such functionality.

Henry Kemp, senior market specialist at Calypso Technology: Sophistication and flexibility are important attributes when conducting scenario analyses. Overlapping the stress-test requirement is the requirement to monitor liquidity more effectively than in the past. Again, institutions need to be able to price/model underlying data in a sophisticated way to achieve this.

Q: What sort of strategies should banks adopt to manage liquidity risk?
Kourloukov: It's essentially a compliance exercise. The two questions I'm often asked are: what the impact will be on business strategy and can we get something out of it in terms of improved cost structure.

The fundamental principle behind the LCR and the NSFR is robust governance of liquidity risk management. This has driven many banks, especially in Southeast Asia, to establish what their liquidity risk appetite and risk tolerance is.

Embedded in risk tolerance metrics should be a top-down/bottom-up approach, cascaded down from the board. In such a scenario, the asset-liability committee becomes more prominent in terms of managing risk and providing advice to the board.

On the treasury side, a funding strategy needs to be established, with effective diversification of resources and tenors. This, in turn, feeds into the institution's contingency funding plan.

HQLA are relatively rare, but the business impact of holding them is significant because it impacts profitability. Institutions may potentially have to reduce costs as a result, becoming 'lean and mean'. It requires a significant rethinking of business models.

Little: Given that the cost of doing business is likely to rise, there is also the potential for liquidity premiums to be applied to the P&L of different business lines. Combined with increased regulatory capital as margin is called, these costs will threaten the viability of some business streams, which will force strategic decisions to be made.

But there is opportunity here too, because the investment in new tools can provide powerful strategic chances to model new business openings or to change tactics. It allows senior management to take control of the business and differentiate their firm. We're already seeing this differentiation occurring across certain business models.

Kourloukov: Certainly in Southeast Asia a trend is emerging where banks are moving more into treasury operations in anticipation of significant draws on their trading books. With relatively low interest rates and the squeeze on margin, new capabilities with respect to data aggregation are valuable and should extend beyond Basel 3. I believe the build-up of the treasury function is a long-term trend.

Q: Because of its reliance on data, shouldn't there be a graduated requirement for compliance by banks operating under different economies/environments?
Kemp: Although a phased build-up of the liquid asset buffer has been introduced by the BIS and that will ease the funding burden as the liquid asset buffer only needs to be 60% initially, it does not change the requirement to be able to calculate the LCR and manage the liquid asset buffer. In fact the data challenge remains the same and banks will have to have systems in place for both the calculation and the management of the buffer by 2015.

Q: How can banks ensure compliance with the new liquidity rules?
Kemp: It's about empowering management by increasing transparency throughout the organisation. Compliance requires banks to have a flexible infrastructure, so that they can respond to the varying demands of individual regulators.

In Asia, because there is a shortage of high quality sovereign and Tier 1 debt, we're seeing different responses emerging from regulators. For example, the Australian authorities are developing a central bank facility for this reason.

Q: What is the best-practice approach in respect of intraday liquidity monitoring?
Kemp: Best-practices require looking at liquidity risk across the entire organisation, on an intraday, daily, 30-day and yearly basis. It involves a change in mindset around determining what's due at what time and where, towards a more granular and real-time approach.

Little: One area related to intraday liquidity monitoring that is at the forefront of people's minds is sequential duty. In response to the collapse of Lehman, the Bank of England reviewed the ways that banks transfer cash around the world.

Historically, the BoE provided a float for payments and settlements, and the end-of-day float could be transferred to another jurisdiction where necessary. This provided additional liquidity, but introduced risk.

While sequential duty systems are now date-stamped, they aren't time-stamped. It would be useful to know the exact moment when the impact of liquidity hits, so the challenge is to introduce time stamps.

There is also a temptation to start managing payments too actively. This could lead to the system jamming up, with payments leaving before another payment comes in.

Q: What is the role of funds transfer pricing in liquidity risk management?
Little: The challenge in funds transfer pricing is to bring all the elements together and produce a comprehensive set of price components that a business will end up being charged for. FTP is an increasingly important discipline, given that costs are rising.

Technology can provide transparency and timeliness around FTP. Business managers should expect information in real time, so that they can manage FTP within understandable terms.

Q: Why is the implementation of Basel 3 being delayed?
Little: Part of the reason why Basel 3 is being delayed is a shortage of expertise and skills necessary to deal with all the different requirements. To manage these demands, firms will need to undertake a combination of buying, building and outsourcing various systems. Ultimately, it will require combining the talents of banks' internal IT resources with what vendors and service providers can provide.