The New Imperative: Active Liquidity Management

Angus Scott, head of product at CLS, outlines the industry and regulatory drivers that mean banks have to be able to manage liquidity intraday; as well as the internal and external solutions which can help them to achieve this.

Intra-day liquidity – the assets needed to settle the daily obligations that arise between banks, broker dealers and their wholesale clients during the course of their business –  is becoming scarcer and more expensive. As a result, managing it effectively and efficiently is an increasingly important priority for the banking community.

On the one hand, major central banks are moving from a stance of monetary loosening towards one of neutrality or tightening. The US is furthest along this path:  the Federal Reserve has raised interest rates by two percentage points (even though it has indicated that it does not expect to hike rates further at this point) and is reducing the size of its balance sheet, which it is expected to conclude by the end of 2019. The Bank of England and the European Central Bank (ECB) have also ended their programmes of asset purchases.

As the availability of central bank liabilities decreases, private markets will need to fill the gap, meaning that banks with surplus liquidity will need mechanisms to lend it to those who require it. Such markets have, of course, existed for a long time and were in common use before the financial crisis. However, regulatory reforms implemented since then mean that money markets cannot simply pick up where they left off. For example, due to concerns about credit, unsecured lending markets are no longer as readily available and collateralised markets that could provide an alternative, such as repo, are expensive because they inflate the balance sheets of participants.

On the other hand, the post-crisis regulatory reforms require banks to take a far more prudent approach to ensure that they have access to adequate liquidity. A number of measures address liquidity, including the Net Stable Funding Ratio, which encourages banks to match the terms of the assets and liabilities on their balance sheets, and BCBS 248,[1]which stipulates intra-day liquidity monitoring requirements.

One of the most important measures is the liquidity coverage ratio (LCR). In its basic form, the LCR requires banks to maintain sufficient high quality liquid assets (HQLA) on their balance sheets to cover their obligations for a 30‑day period in which they would not be able to rely on the markets for funding.

A number of supervisors, however, including the Federal Reserve, the Bank of England and the ECB have adopted a stricter approach. The Bank of England, for example, expects the banks it supervises to assume that their outgoings over the 30-day period all occur before any incoming cash is received. Further it requires that outgoings include not just contractually-committed payments, but also uncommitted payments (if not making them could damage market perceptions of the paying bank) and that banks apply a haircut to their portfolios of HQLA to reflect the risk that even high-quality assets might be worth less in a stressed market.

The Bank of England also expects banks to keep this liquidity reserve unencumbered, meaning that they need to maintain additional assets to collateralise their use of payment systems or to support liquidity lines with other banks.

In short, central banks expect the banks they supervise to hold much higher reserves of liquid assets than they have done historically and the costs of doing this are high.  A recent paper by Oliver Wyman[2]estimates the cost of carry for HQLA assets on the balance sheet at 100bps and the cost of intra-day lines from 50 to 150 bps.

There are also opportunity costs. Another post-crisis measure, the leverage ratio, requires each bank to hold a minimum of 3% equity against its assets on a non-risk-weighted basis, rising to 6% if it is a global systemically important bank (G-SIB). Having to hold large portfolios of high-quality but low-yielding assets in their liquidity reserves prevent banks deploying their equity to more profitable opportunities.

So what can banks do to address these issues? There are certain measures within their own control. The Oliver Wyman report lists a number of areas on which banks should focus to improve their in-house liquidity management including, better monitoring of current positions while investing in enhanced historical datasets and advanced data analytics to ensure that they are able to optimise their use of liquidity over the day. The report also recommends that costs related to intra-day liquidity are allocated to the functions or divisions within the bank that consume it.

While there is much that banks can do individually, however, the biggest savings will be through improved management across the global network of financial institutions.  This suggests the need for a stronger role for providers of both domestic and cross-border market infrastructure services.

Domestic infrastructures, typically in the form of the RTGS systems run by central banks, are critical for efficient liquidity management and many are undergoing renewal programmes designed, among other things, to increase liquidity efficiency.  For example, the ECB is building a liquidity management layer to underpin its three major payment platforms: TARGET 2 (its high-value RTGS system), T2S (its securities settlement system), and TIPs (its recently launched retail instant payment platform). Similarly, the Bank of England, as part of its RTGS renewal programme, is both reviewing the operation of its liquidity-saving mechanism and exploring innovative new concepts, such as functionality to support the synchronisation of payments between systems.

Yet, in a global context, even RTGS systems represent sub-systems within the wider network. True optimisation needs to factor in the interconnectedness of these sub-networks and the central banks, commercial banks, currencies, and high-quality liquid assets of which they are comprised. We are starting to see this panoptic view emerge. CLS, as the global hub of cross-currency settlements, is one of the bridges that link domestic networks. In this capacity, last year it launched CLSNow, a same-day settlement service that enables banks to exchange liquidity positions across currencies with no settlement risk on a near-real-time basis, thereby helping banks to meet their intra-day funding needs.[3]

Looking further into the future, there are other areas where the financial community might look for opportunities to improve liquidity management. One worth examining is the alignment between nostros, money markets, and payment and settlement systems. CLS is actively researching the potential to improve the flow of funds between these different destinations to increase velocity and reduce liquidity traps.

Another concept being explored is to combine the rich transactional data that exists within banks and in systems such as SWIFT’s GPI initiative, with execution and settlement capabilities to create new market places and potentially higher-level optimisation services. Finally, the impetus from the development of distributed ledger technology and the growth of crypto-assets has stimulated a search for new models to manage high-value payments and liquidity flows, whether in the form of central bank digital currency experiments or private sector initiatives, such as the Utility Settlement Coin or R3’s Cash on Ledger work.

Liquidity management has always been important to banks; however, industry and regulatory drivers are increasingly moving it from the green room to centre stage.  Indeed, addressing the liquidity challenges which banks face will be one of the key enablers for the financial industry’s future success. As a result, banks need to act now on initiatives that support this future.

[1]BCBS 248: “Monitoring tools for intraday liquidity management” (April 2013)

[2]Oliver Wyman: “Intraday Liquidity: Reaping the benefits of Active Management” (2018)

[3]The launch of the service is subject to regulatory and all other necessary approvals.

 

Colin Lambert

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