ASIA FIRST BASEL III AND INTRADAY LIQUIDITY MANAGEMENT A QUIET REVOLUTION FOR BANKS

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1 BASEL III AND INTRADAY LIQUIDITY MANAGEMENT A QUIET REVOLUTION FOR BANKS A feature on the forthcoming BASEL III liquidity management regime produced by Asia First in association with SmartStream. ASIA FIRST THE FINANCIAL INTELLIGENCE PLATFORM 1

2 ASIA FIRST THE FINANCIAL INTELLIGENCE PLATFORM BASEL III AND INTRADAY LIQUIDITY MANAGEMENT A QUIET REVOLUTION FOR BANKS During the early liquidity phase of the financial crisis many banks despite adequate capital levels still experienced difficulties because they did not manage their liquidity in a prudent manner. The difficulties experienced which in some cases, created significant contagion effects to the broader financial system, were due to lapses in basic principles of liquidity risk measurement and management. Liquidity coverage ratio disclosure standards consultative document, BASEL INTRODUCTION Since 2008 banks and other participants in the financial markets have seen an avalanche of regulations designed to address the institutional and systemic weaknesses exposed by the Global Financial Crisis. BASEL III (and Dodd Frank), in particular, reshaped the businesses of many financial institutions, particularly banks and have driven some of these banks to reduce the scale or even eliminate risk-taking and balancesheet intensive businesses such as proprietary and derivatives trading. The next set of BASEL III requirements implemented from January 1, 2015 address the liquidity of banks and financial institutions. These requirements may seem less dramatic in their impact on banks business models but in practice these requirements may be amongst the most demanding at an operating and day-to-day decision-making level within banks. The regulators liquidity agenda requires banks to comprehensively address intraday liquidity management and will set a framework that will, directly or indirectly, affect other financial institutions, including shadow banks and general participants in the funding and securities markets. In this article we take a high level look at both the objectives and the challenges involved and the opportunities that may arise from the implementation of these requirements. We also add the recent comments of the US Federal Reserve made on the introduction of new rules in the US in September this year. BASEL III AND LIQUIDITY MANAGEMENT The primary focus of BASEL III and respective domestic legislation has been to increase capital buffers and to improve the adequacy of the relationship between risks taken and capital held. As the Bank of International Settlements (BIS) points out, higher capital buffers can limit the risk of the evaporation of liquidity, because of the critical role that counterparty risk, and credit risk more generally, plays in liquidity crises. Essentially, the more capital held against risks the more market confidence and resilience, so the theory goes. But as the BCBS identified in 2008 (see left panel), sufficient capital was not enough to avert a liquidity crisis across the global financial system. The BCBS described the deficiencies in the then market practices including: inadequate treatment of individual products or business lines; underestimation of the funding requirements associated with contingent obligations, whether contractual or not; limited preparation for potentially protracted market-wide liquidity strains, including a failure to consider these scenarios in stress tests; and overly sanguine reliance on the performance of collateralised lending markets under stress, including those for FX swaps. 1. BIS Working Paper No Ten propositions about liquidity crises by Claudio Borio November Ibid page 8 2

3 BASEL prescribed elements to be incorporated into a bank s intraday liquidity risk management model A bank should: (i) have the capacity to measure expected daily gross liquidity inflows and outflows, anticipate the intraday timing of these flows where possible, and forecast the range of potential net funding shortfalls that might arise at different points during the day; (ii) have the capacity to monitor intraday liquidity positions against expected activities and available resources (balances, remaining intraday credit capacity, available collateral); (iii) arrange to acquire sufficient intraday funding to meet its intraday objectives; (iv) have the ability to manage and mobilise collateral as necessary to obtain intraday funds; (v) have a robust capability to manage the timing of its liquidity outflows in line with its intraday objectives; and (vi) be prepared to deal with unexpected disruptions to its intraday liquidity flows. The BCBS has outlined 17 principles for effective management and regulatory supervision of liquidity risks in banks going forward and in particular, amongst these principles that: [a] bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems. 3 Until last year, much of the discussion around liquidity had been focussed around the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio. These require banks to hold high-quality liquid assets (HQLAs) in order to better safeguard themselves against external shocks and stress scenarios for a period of 30 days and a year, respectively. But the BCBS recognised that binding minimum levels for liquidity coverage alone will not be sufficient and in fact these buffers could act procyclically, moving from being shock absorbers to shock amplifiers. So the focus of the debate changed last year when the BCBS published its paper on Monitoring Tools for Intraday Liquidity Management. The paper outlines a specific set of tools to help national banking supervisors better monitor internationally active banks management of intraday liquidity risk 4. It also provides for greater consistency across regulators following a survey by BCBS in 2009 that identified that regulators across the world were using 25 different measures to assess liquidity alone. A key aspect for banks is the demand for improved intraday liquidity management and reporting. REGULATORY TIMINGS AND EXPECTATIONS 3. BCBS Principles for Sound Liquidity Risk Management and Supervision September BCBS Monitoring tools for intraday liquidity management April 2013 So as the first deadline approaches in many jurisdictions, including Hong Kong, on 1st January 2015, what are the expectations of regulators? Simon Deane, head of Deacons Banking Practice Group in Hong Kong remarks: The BCBS is saying that banks must not only comply with the LCR but that they must also deploy "monitoring tools" enabling them to report their intraday (i.e. at regular intervals during a day) liquidity data to their regulators to facilitate monitoring of banks intraday liquidity risk and their ability to meet payment and settlement obligations under both normal and stressed conditions. This clearly will require many banks to develop new data monitoring, risk analysis and decision-making infrastructure framework. Nick Noble of SmartStream adds: The [BCBS] tools are a wholesale paradigm shift for most large international banks in terms of how they monitor and manage intraday liquidity risks. Consequently, banks will have to understand their intraday liquidity and risks in all their business lines and accounts and will need to show they have total control of their clients flows in addition to their own. This will require revamping current processes since as an industry, we have been accustomed to working on end-of-day reporting and intraday movements on nostro accounts would typically not have been included. And as one European banker succinctly puts it: 3

4 [intraday liquidity management] has been with one or two people in a bank and they were not seen and now this problem gets distributed throughout the whole bank and becomes a very important part of all [bank] activities. CHALLENGES ARISING FROM THE BCBS REQUIREMENTS But how achievable are these regulatory expectations in the current market environment? The reporting requirements compel banks to address the exchange of data and analysis of risk across a wide range of markets, counterparties and correspondent arrangements, each operating and exchanging data historically in an uncoordinated and often inconsistent manner. Commentators and participants seem to agree that the quality and timeliness of data is the key need in making the right decisions on intraday liquidity management risks. Simon Deane of Deacons explains: Despite the common framework the reforms are attempting to develop, there is still a process of translation by regulators into the national context and there will inevitably be differences in interpretation of the requirements and in their implementation in the jurisdictions that decide to adopt the reforms. Nick Noble adds: Banks are also concerned about the process and format for data collection and reporting. Also the impact of much greater visibility of their liquidity positions. There is also the issue of identifying and agreeing on standard reporting requirements between market participants internationally in a way that meets the individual preferences of different regulators. RISKS AND OPPORTUNITIES FOR BANKS AND THE MARKET Nick Noble, Product Manager - Liquidity Risk Management at SmartStream Technologies Nick Noble of SmartStream commented on the challenges for banks and other market participants:- Most bank legacy systems and related processes were built in a world that focused on forecast data and end-ofday data but not on accurate, real-time, liquidity position information. There is also a massive integration problem that banks are facing. The standards applying to the exchange of data by correspondent and agent banks, counterparties and market infrastructure were also developed on end-of-day models and will not meet the new intraday requirements going forward. And there are uncertainties with the application of the new requirements across different regional and national regulators. Another area of agreement amongst practitioners is that given the current state of market infrastructure and unresolved issues on data and reporting, the short term may see an increase in risks for banks managing intraday liquidity. Alan Taylor of ATS Associates 6 warns that: Not every party will be at the same level at the same time in their access to intraday data and their ability to manage intraday liquidity risks. Those that have an advantage in this regard might unintentionally cause instability as they apply that advantage. On the other hand, banks will be faced over time with a vast amount of data on their positions and risks to be assessed and perversely the uncertainty due to data integrity or the complexity of the data and timely risk assessment might 6. Alan Taylor is a capital and funding markets professional providing consulting support primarily to banks and supranational organisations: alan@atassociates.com.hk. 4

5 initially deter them from action and limit their participation as a provider of liquidity to counterparties. Nick Noble also points out: There could also be business risks in this process for correspondent banks. A bank s manager of correspondent arrangements is likely to place more value on the level, frequency and reliability of intraday reporting provided by correspondents rather than on the loose arrangements of the past, whereby a bank awarded its payments business to a correspondent in a certain country in return for an intraday credit line. So what are the opportunities for banks and is there any pay-back from the substantial investments in IT and infrastructure that they will make? ì The obvious long-term benefit perceived by the regulators is that banks will enjoy additional protection as their enhanced intraday liquidity risk and management systems increase efficiency and may reduce counterparty settlement risk and the duration of that risk. It will increase the visibility of risks and the warning signals should other banks and counterparties with whom they deal suffer liquidity problems in times of stress in market liquidity. But over-time, the improvement in the timeliness and accuracy of liquidity-related data will enable banks to gain more efficiency in managing intraday liquidity and cash. The benefits will come both from an improvement in internal decisionmaking but also an overall improvement in market infrastructure. Liquidity Monitoring tools by Type of WHAT IS THE CURRENT FOCUS OF REGULATORS SUPERVISING BANK LIQUIDITY? The HKMA identifies a number of issues: [T]he HKMA expects that the potential Category 1 foreign banks will most likely be international banks that are subject to LCR requirements imposed by their home supervisors on a group basis, once the LCR is implemented from 1 January This raises the issue of the extent to which reliance can be placed on the banks consolidated LCR under home jurisdiction requirements. 7 The HKMA, whilst flexible in its approach, will impose quantitative 7. Consultation Paper Implementation of Basel III Liquidity Standards in Hong Kong (L3) HKMA July

6 liquidity standards on [foreign bank branches] to ensure that sufficient ex ante liquidity is maintained by them to support their local operations at all times (including in times of stress). HKMA also points out the challenge that as international banks often adopt centralised liquidity risk management models, run from head office, so direct control of liquidity may reside outside Hong Kong. ì Even though the HKMA adopts a flexible approach, there will also be a cost to banks operating cross border into the territory through branches as in the case of intra-group inflows and outflows arising from funding operations that are broadly matched, there will effectively be a 25% liquidity cost on such operations. Addressing another area of discussion, the Monetary Authority of Singapore (MAS) talks about liquidity of local Banks beyond local currency: [T]he new liquidity framework will apply to all currencies. Many banks in Singapore hold a large portion of their liabilities in foreign currencies. But the current MLA [the MAS existing liquidity requirements] applies to Singapore Dollar qualifying liabilities only. Extending the liquidity requirements to all currencies recognises the need for banks to manage all their liquidity risks, whether in Singapore Dollar or foreign currency, appropriately. With smaller pools of local currency HQLA s and large non-domestic currency flows, many Asian countries will adopt this approach. As to supervision, the HKMA supervisory regime kicked-off in 2013 which comprised of 41 thematic onsite examinations at selected authorised institutions to assess their compliance with the standards and guidance set out in the HKMA s recently updated modules on Sound Systems and Controls for Liquidity Risk Management and Stresstesting in the Supervisory Policy Manual (SPM). The HKMA also examined authorised institutions treasury and derivatives activities focusing on their control framework for managing market and counterparty credit risk. 9 These thematic visits supplemented more than 400 onsite and offsite visits on general BASEL III standards and procedures. 8. Address by Mr Lim Hng Kiang, Deputy Chairman, MAS to 41st Association of Banks in Singapore Annual Dinner, Banking Stability chapter of the HKMA Annual Report

7 CONCLUSIONS The intraday liquidity requirements of the BCBS represent a wholesale change to the data architecture of the industry and data collection and management by banks. A quiet revolution if you like. In the longerterm all institutions that play a role in payments, settlements and financing with or through banks will feel the direct or indirect impact of these changes. The work required to address the challenges will also be long-term as market infrastructure and reporting standards evolve. Nick Noble adds: The business case for implementing the intraday liquidity monitoring tools is strong both from an operational and regulatory perspective, but it is likely to be a bumpy ride on the road to getting there. Those banks that have more robust intraday liquidity management processes in place and greater visibility of available liquidity and intraday exposures can make a strong case for reducing intraday liquidity buffers, which has contributed to the increased cost of intraday liquidity management. However, for those banks that continue to operate blindly without visibility of their exposures, they will be left behind the curve and won t understand where the risks are. But as Noble indicates, a new regime will need to be tuned as events unfold in the markets. Ultimately, it will take the emergence of a widespread liquidity event to test whether the banking industry has sufficiently developed its intraday risk management systems and the market infrastructure supports more resilient liquidity management. But such an event is an inherent risk of capital markets, despite the work of BCBS and the potential future risks are even apparent in the current benign liquidity environment. Indirect Settlement Buy Side Intraday Nostro Vostro End Of Day Sell Side Direct Settlement Key Cash Management Perspectives, source Smartstream. US UPDATE: SEPT 5TH On September 5th, 2014, the Board of the US Federal Reserve adopted the final rule for the US implementation of the BASEL III liquidity coverage ratio (LCR) in the US, to be implemented on January 1st The rule requires banks to hold a minimum amount of high quality liquid assets as cover for liquidity needs during periods of market stress. 7

8 Janet Yellen, Federal Reserve Chairman commented: As the financial crisis demonstrated, most of our largest and systemically important financial institutions used excessive amounts of short-term wholesale funds and did not hold a sufficient amount of high quality liquid assets to independently withstand the stressed market environment. The new rule will apply to bank and savings and loan holding companies with more than US$50bn in assets, but not those below. For institutions with between US$50-250bn of assets, the rules will be less stringent than those for institutions over US$250bn or with substantial overseas operations. Governor Daniel Tarullo indicated that there will be a later rule tackling branches of foreign banks. Also the new rule will not apply directly to non-bank financial institutions or shadow banks, but Fed officials explained that those non-bank institutions that are deemed systemically important will be subject to individual assessments by regulators. The LCR rules compliment existing requirements for US banks under Dodd Frank that require them to establish enhanced risk management systems and to operate an internal risk-model that calculates liquidity risk, so-called Reg YY. Federal reserve staff at the Federal Reserve meeting said that supervision is going to be a big part of the new regime for liquidity risk management in order to address both the potential for arbitrage of the new rules and also idiosyncratic risks within banks that the rules don t address. Since the implementation of these rules, the Fed officials indicated that they have been conducting regular assessment exercises to assess, qualitatively, the strengths and weaknesses of the liquidity risk management systems within US banks. The rule will be followed by provisions implementing the Net Stable Funding Ratio that will address liquidity and funding risks for banks beyond 30 days. In addition the Fed indicated that it will take account of a bank s reliance on short-term wholesale funding as a factor when setting the amounts of the capital surcharges applicable to the most systemically risky banking organisations. Bloomberg reports the Fed as saying that US banks will be required to hold US$2.5tn in high-quality liquid assets over a 30-day stress period, which is $100bn more than they currently have, meaning that there is currently a shortfall. This Article has been produced by ASIA FIRST THE FINANCIAL INTELLIGENCE PLATFORM In association and with SmartStream provides Transaction Lifecycle Management (TLM ) solutions and Managed Services to dramatically transform the middle and back-office operations of financial institutions. Over 1,500 clients, including more than 70 of the World s top 100 banks, 8 of the top 10 asset managers, and 8 of the top 10 custodians rely on SmartStream s solutions. SmartStream delivers greater efficiency, automation and control to critical post trade operations including: Reference Data Operations, Trade Process Management, Confirmations and Reconciliation Management, Corporate Actions Processing, Fees and Invoice Management, Cash & Liquidity Management and Compliance Solutions. Used independently or as a suite of solutions and services, clients gain a lower cost-per-transaction whilst reducing operational risk, aiding compliance and improving customer service levels. For more information about Published by Asia First Financial Intelligence Limited, Suite 1207, Wing Lok Street, Hong Kong Copyright Asia First all rights reserved. 8