A New Challenge for Banks

By Phillip Straley, President, FNA 

Stories of liquidity pressures have dominated the headlines recently as banks and other financial institutions feel the strain of current market challenges. Even market favourites, such as fast growing fintechs, are feeling the pain of the liquidity shortage. 

For years, the benefits of abundant and cheap liquidity have meant a benign funding environment for banks and the economy as a whole, but changing conditions are demanding a rethink to re-establish control over liquidity in the face of rising interest rates, quantitative tightening and economic uncertainty. 

Payments, both wholesale and retail, are rapidly heading towards real-time processing, a concept that has become synonymous with today’s liquidity landscape. This is particularly demanding for financial institutions and infrastructures that work based on liquidity saving mechanisms, and for this reason liquidity is becoming elusive. What’s more, the current monetary stance makes liquidity very scarce and costly.

As such, the topic of intraday liquidity has grown significantly in importance among banks, particularly in global, systemically important ones. Central banks and supervisors across the world are much more aware of the interconnectedness of markets and contagion risks as a result of credit and liquidity crunches, and the resulting impact on the economy. 

What is liquidity management?

Before we explore how to overcome the challenges, we first need to understand what liquidity management is and how it impacts the way banks and other financial institutions operate. 

Put simply, liquidity management is a bank’s ability to fund assets and meet financial obligations without incurring unacceptable financial costs. It is the role of the bank’s management team to ensure sufficient funds are available to meet demands from both depositors and borrowers. To mitigate liquidity stresses, banks must maintain sufficient levels of high-quality liquid assets (HQLA) as well as access to borrowing lines and other sources of funding. When it comes to intraday liquidity management, the whole point is banks having the money when and where they need it, without excess idle money sitting on their balance sheet. 

There are three core elements of liquidity management operations which should always be at the forefront of a bank’s strategy:

1. Obtaining granular and timely visibility: banks need access to data where they need it, giving them a clear view, at both a granular and intraday level, of positions, payment obligations and cash and funding balances across all relevant accounts and relevant legal jurisdictions and entities. 
2. Having a truly global approach to operations: every bank is at a different point in their journey in this respect,  truly global operations are important to enable integration across all activity across all business units which provides a clear view of needs from every part of the bank which are impacting liquidity positions. This enables tight coordination across treasury, payments operations, global markets, and other business units, supported by core technology.
3. An analytical focus: previously, banks have approached analytics primarily from a regulatory perspective, and while regulation remains a core focus for all banks, they are increasingly focusing attention on directing analytics at the core business problem; specifically, how they can optimise their global payments activity to be liquidity efficient while also managing within other constraints such as meeting customer payment expectations, meeting individual financial market utility requirements, or meeting time sensitive payment obligations. 

However, current economic challenges are changing the game, presenting financial institutions and infrastructures with a fresh set of hurdles as they strive for liquidity efficiency amidst a significant push for real-time processing during a period of abrupt quantitative tightening (QT).

The impact of current market conditions 

It’s impossible to get away from the ongoing economic and cost-of-living crisis, and many people are suffering from the tangible impacts these are having. Global Central Banks’ responses to inflation have been to increase interest rates, a move we have just seen again from the U.S. Federal Reserve at its final meeting of 2022, closely followed by moves from The European Central Bank and the Bank of England. These rate increases have two direct impacts on banks: margin and growth.

Given that lending is a bank’s core business, a rate increase ultimately means a higher return on their Net Interest Income (NII) from lending that’s set at an adjustable rate. However, at the same time, their customers will demand a higher return on their deposit at the risk of increasing deposit outflow to treasuries, money market funds, or competitions. NII movement will then ultimately depend on the relative pace of repricing of assets (loans) versus liabilities (deposits). 

As banks’ own funding costs increase, these are simply passed on to the customer through increased lending rates. To put this into perspective, in 2022 the average interest rate for a mortgage increased from circa 2% to over 5% in less than 12 months. This impacts growth for banks because these mortgages are simply unaffordable for both new customers and existing borrowers, who are either on variable rates or due to renew in 2023, impacting the housing market’s Loan To Value (LTV) ratio and consequently increasing mortgage default rates.

It is imperative therefore, that banks rethink their approach to liquidity management.  

Building blocks for successful liquidity management

Firstly, banks need a real-time aggregate view of their assets and obligations – effective ‘data centralisation’. Most banks struggle with establishing this full picture. Secondly, once they have this real-time granular view, they need to be able to assess this information in the context of their business objectives, such as any cash and capital restrictions and projected cash movements over the next day, week, or month. Thirdly, once these fundamentals are in place, it’s time for them to take action, and this is where newer technologies come to the fore. When it comes to such solutions, banks must consider two things: interoperability; what can work with their current systems and payment rails today and extensibility; how to build real-life workflows within their current system while incorporating new technology, which is where the opportunity to leverage APIs and automated workflows to improve processes becomes a viable option. 

Today, there are two key forces impacting liquidity management. The first is the push for a real-time world. Whether retail or wholesale, everything is now expected to settle immediately or at least much more quickly. This push for real-time payments is having a galvanising effect on the industry, touching every facet of the payments ecosystem, holding great promise for end users in particular. However, in doing so, it places great demands on banks and the wider financial supply chain regarding their stewardship of liquidity.

The second force is the simple fact that we are experiencing the steepest Quantitative Tightening in decades. This tightening cycle, particularly given the speed at which it is happening, only serves to underscore the value of liquidity savings for both participants and the financial system more broadly. We can quantify this by looking at the way the environment has influenced services such as CHIPS, the largest private sector USD clearing system in the world, within which volume and values are both up 4%. There is a clear virtuous cycle whereby volume increases in CHIPS tend to increase liquidity savings and efficiency, such is the dynamic environment we’re operating in currently. 

Cracking the liquidity challenge 

The first step to overcoming any challenge is gaining visibility of what’s at hand. There are many causes of increased liquidity usage and how these could be resolved. So with this in mind, banks must first understand the current liquidity flows if they are to tackle rising interest rates and reduce overall operational costs. To do so, they must evaluate the cash flow characteristics, structure, and stability of each major asset and liability category to determine the effect on operating and contingent liquidity risk. This assessment, combined with an evaluation of the interrelationship of these asset and liability accounts, provides the basis for determining the quantity of liquidity risk across the institution. 

Another core component of liquidity management is determining what is operational money vs. non-operational money. This became relevant after the 2007-2008 financial crisis when changes were made to the way that banks are regulated when they evaluate the deposits they have. This is done by taking a view of how often a client uses the money for payments. Evaluating the balance between operational and non-operational money will allow the bank to better manage liquidity to, say, lend to the public while preserving funds to make payments on behalf of their clients. When liquidity becomes more dear, those operational deposits must be balanced.

Technology as the solution 

When faced with such challenges, banks must be willing to embrace technology. As a leader in deep technology analytics ourselves, there are a number of key technology components we believe to hold the key to cracking intraday liquidity management. 

The first is data centralisation, from data lakes on a global scale to the maintenance of data in core operational systems. The second is regulatory reporting and metrics, and it is encouraging to see an exciting combination of new market entrants and industry incumbents bringing technology powered solutions to the market. Thirdly, there is an abundance of core operating technologies, including workflows, that integrate with payment systems and ledger insights, and finally, we of course have analytics – where we specialise at FNA – providing an increased focus on simulation technology for organising and optimising payments to reduce liquidity costs. Our track record of helping treasury and liquidity teams optimise their liquidity through network visualisation and analytics, and simulation technology, is driving positive market impact. 

By bringing together real-time data and smart algorithms, integrated into payments schedulers and payments gateways, there is a huge opportunity for banks to crack the liquidity challenge. Further, by driving early warning of market stresses and changes in customer payments behaviours, and the ability to manage these, banks can become more resilient.  

There was a time when losing £100-£200m per year in liquidity costs wouldn’t have put a dent in the bottom line for large banks. Times are changing though, and banks must change with them.