The Financial Water Shortage. Achieving cost savings through optimising intra-day liquidity

Transcription

1 The Financial Water Shortage Achieving cost savings through optimising intra-day liquidity

2 Overview Water is the life-blood of the living world. We would not exist without it. Yet in the developed world we do not treat water as a precious resource, we simply take it for granted, assuming that it will always be in plentiful supply. The every-day issue of preserving water has many parallels with today s challenge of managing intra-day liquidity in banking. However, has it been considered that the solutions to both these problems could be similar? Much has been written about the liquidity issues over the past 4 years, but the intra-day issue, where banks depend on one another for the plumbing of cash-flow, is something that needs your attention. Why is Liquidity important? Like water, liquidity is the life-blood of the world's financial institutions. Millions of transactions every day create ebbs and flows of cash moving through a complex network of payment and settlement systems. These movements flow between Central Bank clearing members who act as Credit Providers and their clients, the Credit Users. Banks can run out of liquidity when expected activities do not go to plan and when credit is not readily granted from their Clearing Bank. In times of stress, the Clearer is less likely to risk their own capital and allow a firm to go overdrawn and may instead demand upfront collateral. This is what ultimately led to the downfall of Lehman Brothers as its credit rating and on-going sustainability became a concern. Why is it worth doing? A liquidity buffer insurance policy is an expensive overhead when margins are getting tighter all the time. Borrowing long term cash when credit ratings are falling can often cost in the region of 200bp. For every $1 billion of liquidity buffer held, $20 million p.a. is added to the cost of doing business.

3 Avoiding Liquidity Failure In order to avoid such systemic failures in the future, global regulators under the Basel 3 umbrella are focusing on ensuring optimal liquidity is available. Their co-ordinated action includes developing tighter rules, creating complex reporting mechanisms and ensuring ever greater liquidity buffers are retained. Contingent liquidity buffers are now specifically being demanded for FSA regulated banks to cover intra-day credit utilisation when using the services of a Clearing Bank. The requirement for the buffer is created when credit is extended by the Clearing Bank and payments are made before receipts arrive. Therefore any extension of intra-day credit, even for a minute, requires a contingent liquidity buffer to be maintained by the Credit Users. While all firms are focusing on theoretical liquidity models (what to measure, when to measure, how to report, how much extra it will cost them, etc.), very few seem to be considering how the base settlement liquidity requirements can be mitigated. This is where Elix-IRR believe that the parallels with the solution to a water shortage can help. Figure 1: Overall clearing model

4 Improved intra-day liquidity Elix-IRR s phased approach 1. Enforce a Hosepipe Ban 2. Improve the Reservoir & Mains Network 3. Install a Water Meter Educate to reduce the number of transactions Fix the processing infrastructure to optimise cash-flow netting Charge for using liquidity 1. Enforce a Hosepipe Ban Liquidity management is about ensuring that you are able to settle your on-going liabilities. The mind-set of simply monitoring end of day cash positions will have to change. As the current FSA regulations and the pending Basel 3 rules evolve, banks will have to evidence that they can "actively manage their intra-day liquidity positions and any related risks. To support this, banks will need to constantly analyse their current approach to settlements. Much like a hosepipe ban, where focused watering is still required, the priority needs to be given to those transactions that have a true need to move cash externally. 2. Improve the Reservoir & Mains Network Due to improving levels of automation and focus on cost reduction/off-shoring, Operations teams tend to focus much more on reducing the cost per trade and rarely consider the liquidity implications of their everyday processes. Multiple, product-specific payment systems make improving & co-ordinating the timing of payment instructions more difficult. Settlement netting tools & solutions often exist but are rarely fully utilised in an automated way. For Credit Users, intra-day credit utilisation is not something they have previously proactively measured and therefore many do not have the people, processes or technology in place to determine this position with accuracy as part of business as usual operations. Enterprise liquidity management oversight is complex. Line Operations teams are often uneducated to the issue and opaque Treasury allocations mean few business lines are fully aware of the extent of and drivers behind the costs. Multiple agents per currency increases the liquidity risks significantly. The challenge to achieve this requires increased collaboration across the whole bank. If it s difficult to identify clear ownership of the issue, it will be extremely difficult to allocate responsibility for the execution of the improvement plan.

5 Reserved Liquidity Buffer ($m) Annualised 150 bps ($m) 3. Install a Water Meter Clear and transparent cost allocation helps to educate the receiving business lines on the issue and provides a clear financial incentive for them to change or justify their practices. Liquidity Risk is generally managed by the Treasury however it is Operations who have direct access to the transactions and therefore the settlement data. The ultimate size of the liquidity buffer depends on each entity being able to sustainably compile the data to evidence intra-day positions for all stakeholders. With such data, decisions can be made to improve the processes. As the old saying goes, you can only manage what you can measure! Clearing Banks (i.e. Credit Providers) should strive to ensure real-time balance data is clearly available to all customers. Obvious netting opportunities should be highlighted to them, and pricing agreed for use of their credit limit and resultant intra-day utilisation. Having achieved clarity over the business drivers for extensions of credit, a bank is then much better able to allocate the cost of the liquidity buffer to the appropriate business line. Elix-IRR Case Study Reduced size of liquidity buffer by c. 50% Reduced interbank payments by >50% Reduced intra-company payments by c. 80% Significantly reduced overall liquidity risk

6 Conclusions Elix-IRR s Approach and Unique Experience Our Approach: Focus on Internal Operational Processes Elix-IRR s approach focusses on the internal operational processes to internalise and net as much cash flow as possible. This will help to alleviate the intra-day juggling of instructions and resultant balances. Eliminate Liquidity Usage In our experience up to 75% of an institution s payments across their nostro accounts can actually be inter or intra-company. This can be significantly reduced if people are encouraged to focus on the elimination of liquidity usage, rather than on obtaining the highest Straight Through Processing (STP) rates at the lowest unit cost. Why Elix-IRR? We understand the drivers and tools needed to minimise the intra-day liquidity requirements. We have experience of influencing large, diverse organisations and have devised and implemented programmes of work to measure, change practices and deliver sustainable liquidity risk improvements. Solving the intra-day liquidity issue requires a transformation mind-set. Our deep experience of managing large-scale transformations ensures that change is durable. We have amongst our ranks deep expertise within the financial services sector. Our independent view helps to cut through internal politics, we are able to raise the issue to the right level in the organisation to ensure it receives the right focus. We have access to the key players within the banking network as well as the utilities (such as SWIFT and CLS) to help facilitate the necessary industry changes.

7 About Elix-IRR: Elix-IRR is a strategic advisory firm specialising in all forms of transformation, change, operating models and sourcing strategies. It is comprised of senior professionals from consulting and services firms such as McKinsey, Deloitte, IBM and Accenture, as well as experienced practitioners from industry. We provide practical, pragmatic advice that leads to real results. Elix-IRR Partners LLP Level 3, 20 Abchurch Lane London EC4N 7BB w w w.elix-irr.com