Liquidity management in a post-crisis regulatory environment
Published: May 2010
Given the recent spate of banking regulation prompted by the global financial crisis, treasurers are rethinking their approach to liquidity management. In this Business Briefing we examine the likely impact of new regulation on liquidity management and what this means for treasury departments.
Global shockwaves
Since September 2008 and the demise of Lehman Brothers, regulators across the globe have been trying to understand the causes of the financial crisis. Regulatory bodies have also been introducing new measures in an attempt to ensure that there are no repeats of the recent financial, and subsequent, economic traumas. Inevitably, this regulatory soul-searching has led to issuance of new legislation and guidance:
Post-crisis regulation snapshot
United Kingdom
UK Banking Act
Replacing the Banking (Special Provisions) Act 2008, which expired on 20th February 2009, the UK Banking Act aims to strengthen stability in the UK banking sector. The Act includes the implementation of a new special resolution regime (SRR) for addressing bank failures and protecting depositors.
Financial Services Bill
The Financial Services Bill introduces a range of measures designed to protect the consumers of UK financial services, including the creation of a Council for Financial Stability. One particular provision requires companies to develop ‘living wills’ in order to better understand the risks involved in their business, better cope with periods of stress and be capable of winding down the business in the event of future crisis without excessive cost to the taxpayer.
Europe
Strengthening the resilience of the banking sector – consultation paper
In December 2009 the Basel Committee on Banking Supervision approved this package of proposals, including strengthening capital requirements, restricting excessive leverage in the banking system, building up capital buffers and introducing global liquidity standards.
Cross-border bank resolution recommendations
This paper puts forward recommendations relating to the strengthening of national crisis resolution powers and their crossborder implementation. It also advocates the use of various risk mitigation measures to limit the market impact of future bank failures.
US
Dodd Bill
Senator Chris Dodd’s Credit Card Accountability, Responsibility and Disclosure Act protects US consumers from abusive credit card practices, such as arbitrary interest rate and charge increases and unnecessary fees, for example.
“While it is true to say that much of this legislation deals with consumer protection and orderly resolution of failing banks without the levels of taxpayer support experienced in 2009, the regulators have also concerned themselves with the causes of the crisis and attempted to introduce measures that could avoid widespread market disruption,” says Yera Hagopian, Global Product Manager for Liquidity Services, HSBC.
But what is the impact of this on corporates and their treasury processes? As Hagopian explains, in order to understand the connection with cash management, we need first to appreciate that the financial crisis was ultimately caused by a crisis in liquidity. In other words, the market discovered what every dispossessed homeowner has known for a long time, that you can be illiquid without being insolvent.
Liquidity, liquidity, liquidity
Given this backdrop, though the saying may seem somewhat trite and out-of-date, liquidity can still be defined as ‘having the right amount of money in the right place at the right time’. So, in the context of the cash management and settlement services provided by banks, what does this really mean?
Having the right amount of money
While this saying resonates strongly on the corporate side of the equation, the banks also have an important role to play here. Funding payments through most settlement systems is one such aspect of this role. “Some settlement systems may allow for a small measure of lending by the central bank,” says Robin Terry, Head of Global Banking Sales Europe, HSBC, “but largely payments have to be funded. However, the challenge is that banks’ customers do not always pre-fund payments.” The market has come to rely on intraday lines as standard practice to gloss over timing differences and ensure that attractive rates are not sacrificed and value days are not lost when, for example, investing surplus funds.
So, for instance, a corporate treasurer will make their investment decision mid-morning in anticipation of funds that they expect to come into their account much later in the day. The company’s cash management bank provides the treasurer with an intraday line and the payment is made, but the bank itself has generally had to put up collateral with the central bank to fund the payment. If the bank is a deposit taker, the collateral can be funded from surplus funds (although this does not necessarily mean the funding is entirely free). As Terry says however, “For non deposit takers operating as a cash management provider in a particular market, the cost of intraday liquidity provision can be significant because funding has to be provided from capital.”
In the right place
In the context of cash management, the ‘right place’ is in the correct settlement system and the appropriate currency. Funding/ collateral has to be available in the applicable settlement system and generally in the right currency. However intraday credit lines marked for customers are frequently multi-currency lines, meaning that the liquidity can be drawn down in any one of a number of currencies. “This is highly effective from a credit utilisation perspective,” says Terry, “it avoids a situation where credit appetite to a single counterparty is eaten up by a series of parallel single currency lines each with low utilisation.” However, it does create a potential currency mismatch which in extreme circumstances, could stress liquidity self-sufficiency.
At the right time
Although the crisis has raised awareness that bank funding is not available to corporates ‘on tap’, collateral to oil the wheels of a settlement process is often seen as a given. Even this, though, cannot be drummed up at a moment’s notice as banks do not build up a stable deposit base overnight. As such, additional capital may be required, especially if customers are to be provided with substantial potential intraday lines.
Although the crisis has raised awareness that bank funding is not available to corporates ‘on tap’, collateral to oil the wheels of a settlement process is often seen as a given. Even this, though, cannot be drummed up at a moment’s notice as banks do not build up a stable deposit base overnight.
“The majority of these lines may not be drawn most of the time, but regulators are now looking at stress-testing scenarios when the largest of these lines may be fully drawn and basing capital requirements on these cases,” says Hagopian. Although regulators are wary of adding to stresses in still fragile economies, this type of stress-testing is likely, in the medium term, to lead to an increase in funding/collateral and could lead to increased cost in the provision of intraday liquidity for everyone involved.
Impact on banks
There will be a chain of cause and effect here. Regulation will have consequences for the banks, which will then filter down to the corporate sector. So, what will be the impact of new regulations on the banks and what will this mean for corporate customers?
Some anticipated impacts include:
Focus on reporting.
“The initial focus for most banks has been the requirement to meet detailed reporting requirements. It is true that these are onerous but the real impact for banks is likely to become clearer over time,” advises Hagopian.
Increased operational efficiency.
Previously, the mantra of any good payments provider was operational efficiency. The requirement for operational efficiency has not gone away, because operational incidents can of course, present their own stresses.
Increased risk awareness and differentiation.
Similarly, the requirement to manage counterparty risk is still paramount. However, now with hindsight, all payment providers are recognising that liquidity is not only a raw material of variable cost and availability, but ultimately a differentiator in the cash management space.
Increased barriers to entry.
For new entrants, the capital requirements of funding/collateralising their payments business could represent a very real barrier to entry.
While these effects have not yet come to fruition, potential pitfalls are already being pinpointed. According to Terry for example, “The requirement to manage liquidity more efficiently may run counter to operational efficiency. It is not hard to envisage a situation where the desire to optimise funding requirements leads to delays in submitting payments to settlement systems as banks try to avoid peaks of liquidity utilisation that cause cost spikes.” Ironically, this type of manipulation by settlement banks could create additional operational risk through payments bunching.
While payment schemes understand these risks and are already considering the impacts, the point illustrates the complexity of dealing with regulation and its wide-spread consequences.
What does this mean for corporates?
Until now, the provision of intraday liquidity has played a vital role in the cash management service offering. “Uncommitted, unadvised perhaps but undeniably present,” comments Terry. Will corporates be left high and dry in the future, will costs soar to untenable levels or will some middle ground arrangement be reached?
If cost recovery proves difficult, availability of intraday liquidity may reduce. There are various potential knock-on effects of this development: of course, internally generated cash will become even more important and further resources may be focused on projects to improve corporate liquidity management.
While it is still early days to predict any effects of the regulatory focus on intraday liquidity with great confidence or precision, it is possible to see some signs for the future:
Already in the cash management market some providers are talking about the cost of providing liquidity and there have been predictions that this commodity will not be free in the future. The rationale for such predictions is understandable but it is much harder to predict how such an evolution will take place. Without further regulatory intervention, charging for intraday liquidity will become a competitive issue since the cost base of different providers will vary significantly.
If cost recovery proves difficult, availability of intraday liquidity may reduce. There are various potential knock-on effects of this development: of course, internally generated cash will become even more important and further resources may be focused on projects to improve corporate liquidity management. “However, the standard panacea, tick-in-the-box approach favoured by so many – the appointment of an overlay bank – may no longer yield the desired results,” warns Hagopian. With multiple banks involved in the process and potentially uncontrollable delays in up-streaming of funds from local banks to the overlay bank, liquidity may not be in the right place at the right time, leaving the overlay bank holding the proverbial intraday liquidity baby. Overlay banks may try to push the burden of intraday liquidity provision downstream by obliging local banks to remit funds before they have been collected but the latter are likely to resist the imposition of an additional cost without any return. Therefore, the separation of ‘transaction bank’ and ‘overlay bank’ may no longer be feasible. This will mean that corporates will need to revisit their existing banking structures and practices.
In order to reduce the reliance on bank-provided liquidity, it is likely that more fundamental organisational change will take place. This could be through the creation of an in-house bank, centralisation of payables and receivables functions and/or centralisation of accounts as far as possible, while preserving access to relevant clearings systems, for example.
For those corporates operating in euro, the impact of the regulations discussed above may be a catalyst for the centralisation of accounts, or for those that SEPA failed to activate. “After all, losing a day’s value on your entire cashflow is a far better business case than slightly lower fees or hard to quantify administrative savings,” says Terry. “However a word of warning is required: not all centralisation projects are equal. A project to centralise merely the payments of the business is likely to add to the liquidity stresses.”
Liquidity management solutions
Assuming that some degree of account centralisation has been achieved, what can corporates do beyond structural change?
According to Hagopian, one of the most effective tools to maximise earnings from transactional balances without incurring operationally intensive overheads is the superimposition of a crosscurrency notional pool over centralised accounts.
Diagram 1: Notional cross-currency pool
This allows the consolidation of funds without the need for physical conversion or the daily chase for the best FX rates. The avoidance of daily conversion also minimises the requirement for external settlement which can impose additional strain on already stretched intraday liquidity. The funds remain in the underlying currencies, ready to be used to fund transactions on the following day but at the same time interest costs are reduced on potentially overdrawn currency positions. From an administrative perspective, interest is calculated and applied in the original currency resulting in transparency from an intra-group pricing and taxation perspective.
Last but not least, operational risk and reconciliation requirements are radically reduced by avoiding the need for currency conversions since it is the bank that takes the currency positions into its books.
“If the cross-currency pool is overall in surplus and it is company policy to pursue an active investment strategy, the surplus can be drawn down from the pool and invested in an approved investment vehicle such as money market funds,” says Hagopian.
So, while many potential difficulties surrounding proposed regulation have been identified, there are solutions available to corporates that have already been tried and tested.
Going forward
What still remains to be seen, though, is how new regulations will actually be enforced and whether the geographical playing field will be level. “There is far greater recognition than in the past amongst regulators that banks, systems and currencies are inextricably linked and there has been more cross-border consultation than seen before in drafting new regulations and guidelines,” concludes Terry. However, this alone cannot provide a guarantee of uniformity. Ultimately the responsibility of each regulator is to its local depositors and tax payers. Corporates should therefore ensure regular dialogue with their banking partners to keep abreast of the latest developments and work together to find optimal solutions.
Global payments and cash management – cash management redefined
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