Liquidity challenge and governance for the banks

Crisis arises when banks are unable to roll over short-term financing causing investors' confidence to take a nosedive, which leads to liquidity congestion within the financial institutions. 

Liquidity coverage ratios aim to strengthen banks against adverse shocks by eliminating structural mismatches between assets and liabilities, encouraging more stable sources of funding – medium and long term rather than short-term options. 

Meeting liquidity requirements have proven to be an even bigger challenge than those of capital. For many banks, these requirements are "the iceberg below the water".

Additional standards will necessitate operational, financial and structural changes and a move away from short-term wholesale funding towards a longer-term funding strategy.

It is evident from observations that any bank will find this difficult, not least in terms of reduced profitability. It will be costly for banks to adjust their balance sheets by holding more,     relatively low-yield, high-quality liquid assets; raising more expensive retail deposits along with medium and long-term wholesale funding. At the same time, they will have to reduce long-term lending as well.

Illustration: TBS

These challenges will be compounded because many banks will be seeking to make similar adjustments at the same time while the market will be moving against them. With varying severity, depending on the type and size of the bank, they will all need to act at the same time to ensure compliance. 

Many banks will also face significant costs for meeting other aspects of the new liquidity requirements, such as: assembling and reporting the necessary data, running a wide range of stress and scenario tests, modelling cash flows, monitoring and assessing their maturity mismatches, checking the concentrations of funding and the availability of unencumbered assets.       

Holding additional liquidity to meet 'pillar 2' requirements and putting in place more robust recovery plans to cover both capital and liquidity will also be a challenge. For many banks, these costs combined with the impact of other regulatory changes will force changes in their business models and organisational structures.

Banks are not the only ones who will feel the heat. The liquidity requirements, in addition to those from within the Basel array and from other regulations, will have a knock-on effect on other parts of the financial sector, e.g., asset managers, insurers and the finance industry as a whole. Infrastructure and mortgage lending will feel the strain of reduced funding and an overall lack of liquidity.     

To meet specified corporate governance requirements, the management will be required to assess the company's liquidity risk tolerance at least annually. At the same time, they will need to approve the liquidity risk management strategies and oversee the execution of those strategies.

To meet specified corporate governance requirements, the management will be required to assess the company's liquidity risk tolerance at least annually. At the same time, they will need to approve the liquidity risk management strategies and oversee the execution of those strategies.

To project cash flow needs over various time horizons, short-term cash flow projections would be required to be updated daily while long-term cash flows would be required to be updated at least monthly. The cash flows would be required to be comprehensive and provide sufficient details to reflect the company's capital structure, risk profile, complexity, activities and size. 

To undertake regular stress testing, the cash flow projections would be required to be stress-tested at least monthly to measure liquidity needs at 30-days, 90-days and 1-year intervals during times of instability in the financial market. 

Stress-testing must incorporate a range of stress scenarios to account for bank-specific stress, market stress and a combination of the two. The results of the stress-testing should be used to determine the size of the liquidity buffer and to contribute to the quantitative component of the contingency funding plan. 

To establish internal limits on certain liquidity metrics, specific limits should be imposed on the concentration of funding, the number of specified liabilities that mature within various periods. Similar boundaries should be imposed on the balance sheet exposures and other exposures that could create funding needs during liquidity stress events. 

Banks are required to maintain a contingency funding plan that identifies potential sources of liquidity strain and alternative sources of funding when usual sources of liquidity are unavailable. The plan would be required to include four components: quantitative assessment, event management, monitoring and testing.

To fully achieve articulation, banks will need to make sure they are capable of measuring their liquidity risk. The lack of pertinent data on risks is an impediment for not only banks but for many financial service firms in attaining better liquidity and risk management. 

Banks must change their methods of balancing their liquidity risk and their role as liquidity providers by restructuring liquidity management. Liquidity risk exposes banks to financial hardship. Banks need to take an attempt to control liquidity risk factors by balancing cash inflows and outflows and even by holding liquidity cushions for strategic purposes.     

When a crisis hits, banks limit their exposure to firms connected to the cause and these firms, including other banks, will fare worse. Being exposed to too much liquidity risk can leave banks to face fleeing investors, deposit withdrawals, rating downgrades and tougher financing. 

Banks, therefore, tend to provide liquidity in counter-cyclic ways: too much when the economy is running hot and too little when the economy takes a turn for the worst. Banks should return to more conservative policies and aim to improve cracks in their systems including improvement of information systems and more accurate models with more realistic assumptions. 

Banks need to find a way to prevent the counter-cyclic trend and ensure that actions by banks,      meant to secure their own liquidity, do not actually make matters worse for all parties. With the changes in policies, there will be a need to evaluate such strategies before a crisis strikes, in an attempt to prevent or limit the intensity of the damage. 

The analysis of liquidity requires bank management not only to measure the liquidity position of the bank on an ongoing basis but also to examine how funding requirements are likely to evolve under various scenarios, including adverse conditions.

Above all, as per the ongoing approach based on internal and external construction, the banks should develop a structure for managing liquidity, for measuring and monitoring net funding requirements, managing market access, developing a contingency plan, planning for foreign currency liquidity management, establishing internal controls for liquidity risk management, ensuring timely public disclosure in improving liquidity, analysing liquidity utilisation in a variety of 'what if' scenarios. 

Many banks are considering and implementing the available 'quick wins' and relatively easy fixes that would enable them to meet (or move towards meeting) the requirements. However, some banks may need to take more drastic actions to change their business models and restructure their balance sheets, either to meet the liquidity requirements or in response to a combination of these requirements and the wider regulatory reform.

Md Kafi Khan is the company secretary of City Bank Limited.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.