Intraday Liquidity Risk Management: Why development is required from a Risk Management rather than from an IT perspective

Transcription

1 Double Effect Working Paper on RISK/ALM Intraday Liquidity Risk Management: Why development is required from a Risk Management rather than from an IT perspective Laura Koppens Elmo Olieslagers Jeroen Davidson June 2014 Copyright 2014 Double Effect

2 Table of contents Intraday Liquidity Risk Management: Why development is required from a Risk Management rather than an IT perspective Executive Summary 1 Basics: what is intraday liquidity management? 2 Why improve per today? 2 Recommendation: organise from a 3 lines of defence perspective 5 Prepare: what to consider when you implement this model? 5 Double-check 7 Conclusion 8 About us 9 Double Effect Working Papers on Asset & Liability Management and Risk outline Double Effect s current vision on relevant topics within these fields. The working papers are primarily aimed at encouraging discussion and may be cited when references are made. For questions related to this paper, please contact the author: elmo.olieslagers@doubleeffect.com

3 Executive Summary Managing intraday liquidity risk is a key element of a bank s overall liquidity risk management framework. By means of this opinion paper, we argue that managing this risk demands a higher priority. The rationale is that increased volatility in financial markets, combined with decreased levels of trust in the financial sector requires enhanced intraday monitoring tools and oversight. Managing intraday liquidity risk ensures that expected payments run smoothly and avoids negative signalling effects in the market. We advocate a combined approach which not only focuses on improving the insight into the flows but moreover enhances risk management. In September 2008, the Basel Committee on Banking Supervision (BCBS) published its Principles for Sound Liquidity Risk Management and Supervision (the Sound Principles), which provides guidance for banks on their management of liquidity risk and collateral. Principle 8 of the Sound Principles focuses specifically on intraday liquidity risk and states 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. There are four major reasons to rethink intraday liquidity management on short notice: 1 Business sense: missing a (critical) payment may result in penalty fees and also reputational damage 2 Risk management: payment behaviour has a signalling effect and disturbed behaviour may give the wrong impression to your clients 3 Regulatory compliance: banks with international activities must adhere to the monitoring tools of the BIS paper 1 4 Market infrastructure developments: it offers opportunities to streamline your intraday collateral management There is a common notion in the market that improving intraday liquidity risk management predominantly requires a number of IT and operational changes. As such, projects aimed to improve data quality and payment flow controlling are regularly identified. Although these improvements are important, they are only a derivative of the actual necessity. Our recommendation is for a bank to start with reviewing its governance and operating model, to ensure and demonstrate that it is in control; as control is an important requirement both internally and for regulators. We advocate the organisation of intraday liquidity risk management according to two design principles: 1 Manage intraday liquidity risk within all three lines of defence 2 Manage intraday liquidity risk by using the COSO 2 II enterprise risk management model These principles provide the structure to prove that the bank is in control, they help to determine the appropriate controls and prevent unnecessary IT & operational investments. Furthermore, following the COSO II model on a per entity basis, will help to distinguish effectively between legal entities and remain in control. We recommend this approach as the set-up and requirements for cash management differ from country to country. 1 Note that liquidity risk is a far more important risk for a bank than solvency risk The ILAAP concept amongst others is currently being used by the European Banking Association as a harmonized standard for liquidity supervision and will become a European standard. See discussion paper draft methodology for assessment of liquidity and funding risk under SREP [EBA-DP ]. 2 Committee of Sponsoring Organizations of the Treadway Commission 1

4 Basics: what is intraday liquidity management? Intraday liquidity are funds which can be accessed during the business day, enabling banks to make real time payments. Following this definition, intraday liquidity risk is the risk that a bank fails to manage its intraday liquidity effectively, which could render it unable to meet a payment obligation in time, thereby affecting its own liquidity position and that of other parties (BCBS, 2013). Intraday liquidity management is intended to mitigate these risks and to ensure that a bank is able to meet its payment obligations in a timely manner, as cost effective as possible, and avoid reputational risk. Sources of this type of liquidity include central bank reserve balances, balances on nostro accounts, liquid assets on the balance sheet, payments received and (un)committed credit lines. This paper will focus on the approach a bank can take to formulate an active intraday liquidity management strategy and what the benefits of this strategy will be for a bank. Why improve per today? If one would ask a treasury organisation of an international bank around 2005 about their core goal regarding liquidity management, the answer was typically expressed by using the iceberg principle. This meant they focused on monitoring the high impact transactions. As a result, banks typically organised themselves whereby wholesale flows, cash positions at the central bank and collateral flows at key clearing houses were managed intraday. Retails flows on the other hand were followed in a more aggregated manner, as these were assumed to be less volatile. The intraday liquidity was predicted based on the contractual obligations only and assumptions were added for client behaviour based on the contracts. The team focused on monitoring the expected in- and out- payments to ensure everything went according to plan, and some dedicated team members investigated the unexpected cash transfers or claims received. Note that the focus at this time was not on intraday positions, but more on the expected end-of-day position. Furthermore, in pre-crisis times it was not uncommon for payments to be put on hold, waiting for additional payments to flow in. Now following the iceberg analogy, what one does not monitor, can cause an issue With the Lehmann Brothers bankruptcy as the visualisation of the 2008 liquidity crisis in mind, banks realised that insight under such stress events requires real-time monitoring of all cash transactions, and not just of the high nominal transactions. Note that this real-time monitoring still relates to the expected end-of-day position and not to the actual intraday position. Projects were initiated by banks to ensure that transaction flows from wholesale and retail trading, and processing systems were interfaced in real time to a centralized cash management system, enabling centralized payment flow control. Now the cash management team still was doing the same, however grew in its responsibilities and managed the flows from a group perspective. This required training the team as well in understanding the retail cash flow behavioural patterns (i.e. payments of large corporates on certain dates [not time] for certain industries) to increase managing the expectations. 2

5 Why improve per today? The cash management team started advising treasury on significant cash in and outflows, as a result from enhanced detailed and real-time insight. A first step towards not only monitoring but also proactive contribution to liquidity management. Now we are in the age of increased volatility in financial markets, where missing an expected payment to a counterparty can easily trigger negative signalling effects with a direct impact on a bank s intraday cash, collateral position and reputation. In addition, there are new stringent regulatory requirements regarding intraday liquidity monitoring. This means that banks are expected to start monitoring their actual (intraday) positions and the timing of the payments, instead of the expected end of day position. In a bit more detail, the following drivers are forcing banks to rethink their set-up: Business: Penalty fee / reputational damage when missing a (critical) payment Until now, there has been no interest charge on intraday liquidity. Given this, banks have only been concerned with their end-of-day balance, as there is an overnight charge on negative balances. However, there are signals that market parties rapidly start to introduce daylight overdraft fees if intraday negative balances if these are not replenished before a specified time (for the moment unstructured and not based on a standard). The introduction of more time critical payments as a result of central clearing 3 (which will become mandatory under EMIR) is an important development as well. These payments have to be settled immediately, to avoid fines. Failure to do so can consequently lead to reputational damage. POTENTIAL IMPACT: reputational risk and increased funding costs Risk Management: Payment behaviour has a signalling function A primary goal of a bank is to take care of unhindered payment processing for their clients. In general, banks fulfil their interbank payments every day in a similar pattern. Deviations from this pattern (for instance a bank fulfils its payments later than usual), could indicate intraday liquidity issues at the bank. Furthermore, trust between banks has diminished due to the financial crisis. Banks increasingly monitor each other s behaviour. The increase in monitoring tools following enhanced regulatory monitoring requirements gives banks the possibility to better monitor their counterparty s behaviour. This enhanced monitoring impacts the bank in two ways: Firstly, a bank needs to control its own payment behaviour to avoid negative signalling. Secondly, a bank can use this for assessing counterparty risk. POTENTIAL IMPACT: heightened counterparty risk management from counterparties 3 Central counterparties such as LCH call the variation margins intraday. 3

6 Why improve per today? Regulatory: Enhanced regulatory monitoring requirements The Basel Committee on Banking Supervision (BCBS) published the monitoring tools for intraday liquidity management in April These monitoring tools are in addition to the Basel III liquidity monitoring tools, since these do not include intraday liquidity within its calibration. Reporting of the BCBS monitoring tools will commence on a monthly basis starting January 1, Furthermore, intraday liquidity risk is covered in Dutch ILAAP, of which its concept is expected to be implemented across Europe in The European Banking Authority (EBA) is currently transforming the ILAAP concept to a harmonised European standard for liquidity supervision. POTENTIAL IMPACT: increased regulatory reporting, fines or even larger liquidity buffer requirements when rules are not adhered to Market infrastructure: T2S offers opportunities to streamline your intraday collateral management TARGET2-Securities (T2S) is a new European securities settlement engine which aims to offer centralised Delivery-versus-Payment (DvP) settlement in central bank funds across all European securities markets. The project was initiated by the European Central Bank (ECB) in 2006 and is currently in the stage of development. T2S will be implemented in four waves between 2015 and The fundamental objective of the T2S project is to integrate and harmonise the currently highly fragmented securities settlement infrastructure in Europe. Via T2S there is the possibility to centralise the banks collateral assets in a single pool to maximise their use and simplify the transfer process.t2s brings together over 20 Central Securities Depositories (CSDs) in the EU integrating all the securities and respective cash accounts. This means a bank no longer needs to keep buffers in multiple locations as securities are no longer blocked in a local market. Improved liquidity mechanisms are available as a result of the proximity between T2S and TARGET2. This means banks can fully make use of the TARGET2 account they already hold at the central bank. Furthermore, banks can reduce their liquidity (cash or securities) at CSD s due to one single settlement platform with less failures. POTENTIAL IMPACT: liquidity management can centrally manage the collateral requirements at various parties (e.g. Clearing Houses, Collateral Agents, and Central Banks). The number of collateral cash accounts that need to be monitored can be reduced resulting in lower operational risk and expenses. 4

7 Recommendation: organise from a 3 lines of defence perspective Most published papers argue that improving intraday liquidity risk management mainly requires a number of IT and operational improvements 4. As a result, projects aimed to improve data quality and payment flow controlling are regularly identified 5. However, whilst many of these initiatives are important improvements, we believe this is a derived requirement. We recommend that a bank starts with enhancing its governance and operating model to ensure it is in control and can provide evidence both internally and to regulators. We advocate organising intraday liquidity risk management according to two design principles: 1 Manage intraday liquidity risk in all three lines of defence 2 Manage intraday liquidity risk by means of the COSO II enterprise risk management model Three lines of defence concept The purpose of the three line of defence approach is to have effective risk management and oversight in place. Typically at a bank, the first line is the business itself, where line managers and risk support are required to monitor the risks they are taking. The second line is made up of central risk managers, compliance and the finance function, who typically report to the chief executive, or the board, and not to business unit heads. The third line consists of the auditors (internal and external), bringing an independent perspective. This would be overseen by a committee of the board, usually made up of non-executive directors. The 3 lines of defence approach does not follow a formal and pre-defined format. The model is considered differently by different banks. For example, some banks consider the compliance function as the second line of defence, whilst others consider it as the third line. One can consider the following as a starting point: The first line is responsible for managing the intraday liquidity risk The second line is responsible for supervising and challenging the first line The third line is responsible for provinding independent assurance COSO II enterprise risk management model To manage your intraday liquidity risk, we recommend to control (or accept) the underlying risks. To ensure that you manage your risks correctly, we advise the use of the COSO II enterprise risk management model. This risk management model is generally accepted by auditors, and is already common practice in many banks for the management of their operational risks. 4 See for example: Swift (2011) and Dovetail (2012) 5 Payment flow control has limitations with respect to intervening in all payments since the role of a bank in society requires the unhindered payment processing for retail and corporate clients 5

8 Recommendation: organise from a 3 lines of defence perspective To assess the intraday liquidity risks, it is adviced to do this on an entity (either legal or geographical) basis and with specific local controls and evidencing (reporting) per entity. Intraday liquidity risks will differ S T R A T E G I C O P E R A T I O N S R E P O R T I N G C O M P L I A N C E per entity due to differences in the nature of the business as well as differences in the local payment system 6 ; resulting in one size does not fit all for the implementation of an intraday liquidity management framework. The implementation of the COSO II risk management model allows banks to distinguish between entities. The picture on the right depicts the COSO II risk management model 7 : ENTITY-LEVEL DIVISION BUSINESS UNIT SUBSIDIARY Prepare: what to consider when you implement this model? When considering the intraday liquidity management components and the traditional three lines of defence concept, COSO II framework can assist in answering the following questions: Topic Internal environment Objective setting Event identification Risk assessment Risk response Control activities Information & Communication Monitoring Description What is the bank s risk appetite for (Intraday) Liquidity Risk? What are the bank s objectives for intraday liquidity risk? An example of an objective could be: The bank wants to be able to fulfil all payment obligations in a timely manner What are the internal and external events affecting the achievement of these objectives? Based on these events; what is the likelihood of the risks materialising and what is the impact when the risk has materialised? How does a bank respond to its intraday liquidity risks? When the risk is high, the risk could be reduced or avoided When the risk is relatively low, one could also decide to accept the risk Which controls will a bank implement to reduce or avoid its risks? When implementing the controls we recommend implementingt a mixture of the below three types of controls: A preventing control for example a buffer A detecting control for example trigger functionalities A mitigating control for example a payment flow controller How will a bank report on its intraday liquidity risk? We recommend the implementation of at least the following two reporting types: Management reporting in line with the monitoring indicators set by Basel Ad-Hoc reporting, a communication can be sent in case of an event How will you monitor the risk management process to verify if based on this process the bank is still able to manage its intraday liquidity risk? 6 Differences in payments systems are for example: In Russia, all payments are settled in four different batches per day, i.e. there is no gross real time settlement. In Singapore, the MAS does not provide banks with an Intraday Credit Facility. In Australia, all gross payments need to be collateralized. 7 COSO,

9 Recommendation: organise from a 3 lines of defence perspective Double-check Finally, when the intraday liquidity management is implemented we recommend checking that the controls conform to the COSO II model: Is my risk oversight arranged properly? McKinsey offers another way of looking at the concept of risk oversight where the resilience of the business model is the first line (McKinsey, 2010). The company s skills and capabilities to deal with risks is the second line, whilst the third line is not organisational or people-based at all, it is the group s financial strength to absorb risks (a balance sheet defence, in other words). Based on this concept of risk oversight, we recommend a final control for your intraday liquidity risk management. Are the controls you implemented aiding in improving the flexibility, skills and capabilities and the financial resilience of your organisation? As an example, the below table provides a number of controls we see regularly for each line of defence: Verification of the intraday liquidity controls Line of Defence Description Possible controls for Intraday Liquidity Risk Flexibility of the business model Flexible business models allow for swift reaction to specific risk events Diversified intraday funding sources Good SLA with correspondent banks Contingency procedures Skills and capabilities Advanced skills and capabilities of an organisation to create insight and foresight allow for early recognition of structural risks Real time cash management system Real time collateral inventory management system Payment flow controlling functionality Intraday execution staff with knowledge of risk management (Intraday) risk managers with knowledge of business specifics An early warning communication plan of unexpected movements as noted by the business to the intraday team Financial buffer Financial strength to absorb intraday liquidity risks Intraday liquidity buffer (consisting of diversified sources of intraday funding) Stress test functionality 7

10 Conclusion Managing intraday liquidity risk is a key element of a bank s overall liquidity risk management framework. By means of this opinion paper, we argue that intraday liquidity risk management demands higher priority for improvement. The rationale is that enhanced volatile financial markets with decreased levels of trust require enhanced intraday monitoring tools and oversight. Its objective is to ensure that expected payments run smoothly and avoid negative signalling effects in the market affecting the perception of market access. We argue for a combined approach with not only focus on improving the insight into the flows but moreover enhancing the risk management of intraday liquidity risk. Our recommendation: Manage your intraday liquidity risk with the COSO II enterprise risk management model in all three lines of defence. The authors wish to thank Michel Bax, Paul van de Kamer and Ronald Roks for their important contributions as subject experts to this working paper. Elmo Olieslagers is the general manager of Double Effect Germany and is a change expert with a broad experience within Treasury and ALM environments. Laura Koppens is management consultant of Double Effect and expert intraday liquidity management. Jeroen Davidson is a management consultant of Double Effect. 8

11 About us Double Effect is a young and dynamic consultancy agency specialized in strategy translation and implementation. Within the financial industry (banks, insurance and asset management companies) we aim to enhance the commercial effectiveness of operational processes. With extensive experience and solid process, product and IT knowledge we are able to translate strategic issues and concepts into a practical implementation approach, ensuring results being firmly embedded in the organisation. We differentiate ourselves by total client focus, a flexible and objective approach and innovative performance commitments. Double Effect means quality, proven experience, integrity, professionalism and commitment. We want to fully understand our client s business in order to add value with our commitment and advice. The Netherlands headquarters Hullenbergweg CP Amsterdam The Netherlands Phone +31 (0) Singapore office 137 Market Street #03-01 Grace Global Raffles Singapore Phone Germany office Mainzer Landstraße Frankfurt am Main Germany Phone +49 (0) References Basel Committee on Banking Supervision, Monitoring Tools for intraday liquidity management, Bank for International Settlements, April 2013 Committee of Sponsoring Organizations of the Treadway Commission (COSO), Enterprise Risk Management Integrated Framework, COSO, September 2004 De Neef, P.L, Baneke, P.J.J., and van Wijck, J.F., Supervision manual: Principles for the internal liquidity adequacy assessment process (ILAAP), De Nederlandsche Bank, July 2012 Dovetail, Intraday liquidity management: Compliance Requirement or Competitive Opportunity?, 2012 Gerken, A., Hoffmann, N., Kremer, A., Stegemann, U., Vigo, G., Getting risk ownership right, Mckinsey, November 2010 Swift, Managing liquidity risk: Collaborative solutions to improve position management and analytics,