Insight & Analysis

To get ahead, join the ‘Committee’

Published: Aug 2020

There’s little advantage in treasurers trying to manage financial risk from the outside. To make a difference, and manage funding and liquidity risk more effectively, joining the asset and liability committee is vital, argues one treasurer active in the banking sector. Here’s why.

Cycling up to the top of a hill

“Who doesn’t secretly enjoy reading an aphorism that actually makes sense?” asks Richard Burrows, Treasurer, British Arab Commercial Bank (BACB). Not for him the lofty ‘what you imagine, you create’ – it never really works in practice, he states, “at least in my experience”. Instead, he favours the less life-affirming but “highly practical” maxim of ‘If you live in a country run by a Committee, be on the Committee’.

For those like him working in what he refers to as “the crusty world of Treasury”, that Committee is the Asset and Liability Committee (ALCO). Chief among the ALCO’s duties is considering and managing capital and liquidity risks where “the materials are always technical, and the debates always intense”.

Of course, all businesses will have a version of an ALCO, even if it is just a Finance Director and a big spreadsheet. But irrespective of size and sophistication, one challenge for many ALCOs, not least in a crisis, is distinguishing between funding risk and liquidity risk, suggests Burrows.

“Though these are often conceptualised as one risk, they are best separated,” he believes. “After all, banking licences are only awarded once the regulator is satisfied that adequate levels of capital and liquidity will be maintained ‘at all times’, so not only encompassing times of relative calm, but also periods of stress – and this year has provided more than its share of the latter.”

Managing funding risk

These concerns, whilst understandably acute in the current environment, are nothing new. In fact, managing funding risk is part of the treasurer’s day-to-day business. In its simplest form, says Burrows, the question is thus: “Can I maintain my current levels of funding and source the increased levels of funding required to grow my business?”

For BACB, funding takes various forms. Part of its funding base may be funds held on account or in short-dated call notice accounts. Focus is required to ensure these are as stable, or ‘sticky’, as once assumed. Some funding may be longer term in nature and therefore matures and rolls over on a regular basis. Some of this may have once been long-dated, but is now approaching the maturity date.

ALCOs are well used to monitoring structural ratios like the Net Stable Funding Ratio (NSFR) and hypothetical stress scenarios, such as the Liquidity Coverage Ratio (LCR). Treasurers who study actual cash flow profiles should be the first to notice any emerging concerns. The most obvious signs of stress in Burrows’ world are falling balances or the need to pay up to roll maturing funds. Given this is a frequent occurrence, the question remains, how, and when, do you know when funding shortfalls are a sign of stress? How indeed?

“A prudent ALCO monitors a range of metrics and will be prepared to accept that the embedded assumptions will require validation and, potentially, adjustment,” he explains. “The assumptions associated with funding risk are largely assumptions about customer behaviours. If you’ve chosen to borrow from retail customers, part of that choice was probably down to assumptions about the cost of the funding. The corollary is that you don’t know all the customers, even if you feel confident that you can predict their behaviours.”

If, however, a smaller number of larger customers are relied upon, the likelihood is that you do know them. “And the better you know them, the better chance you have of being able to sense when the day-to-day negotiation on the rate or maturity is morphing into a reassessment of your creditworthiness.”

For LCR, regulators attach a far higher risk factor to institutional funding than to retail funding. This is because the institution borrowed from is likely to have a well-resourced risk function and a credit governance framework that scans the horizon for emerging risks and drills down into the detail to understand bank funding risk requirements. “In management parlance, the risk becomes the issue when a borrower falls off the approved credit list of its lender,” says Burrows.

Enter liquidity risks

When funding risk becomes a funding issue, it makes way for liquidity risk. If the funding issue means that business growth is curtailed, this may be very painful for some stakeholders to accept, comments Burrows. If the funding issue, however, means that the balance sheet needs to shrink, that is painful for all stakeholders. “As one firm’s asset is another firm’s liability, a funding issue for one, can quickly become a sore systemic funding issue.”

In the world of trade finance, the duration of lending tends to be relatively short (around 180 days). With this in mind, a lender’s balance sheet may be able to shrink in a predictable manner by simply allowing loans to mature and therefore not requiring future funding.

For the borrower, too, provided that a particular transaction is financed to maturity, then the funding risk is mitigated. The reality, says Burrows, is that the borrower’s business model is based on flow, and likely relies on an assumption of rolling over the funding into the next transaction and the next, and so on.

The 2020 crisis is still evolving, and will do in unexpected ways. But while crises come and go, risks remain perennial and need to be managed. So, what is the solution? For Burrows, it’s “good, old-fashioned relationship management”.

“Customer-to-customer relationships are clearly key, but so are those closer to home,” he says. “The better a bank’s relationship managers know what their Credit Committee and ALCO are discussing, the better they can communicate with their customers.” In other words, he says, “be on the Committee”.

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