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Liquidity Management & Transaction Banking

This article is written by JoostBergen, an associate of TSCL. Hehas many years experience inLiquidity Management andTransaction Banking. Joost is bothan experienced advisor and trainer,with a specialism in liquiditymanagement in relation to theFinancial Supply Chain.

Scenario

Over the last five years, the liquidityspace for transaction banks haschanged dramatically. The impact ofthe liquidity ratios of Basel III – theLCR (Liquidity Coverage Ratio) andthe NSFR (Net Stable Funding Ratio)has been substantial. In particular, theintroduction of the formal short-termLCR buffer and the stricterqualification of which assets qualify asHQLA (High Quality Liquid Assets) tobe held within the buffer has changed.

And now, the requirement tomeasure and to report for intradayliquidity (BCBS 248) implies that abank must be able to record andreport upon its peak cash exposuresin real-time across the working dayin significant currencies from theirlargest FIs, corporate clients andcorrespondent banks.

All of these changes affect the valueof HQLA, which must be reserved onthe bank’s balance sheet. And to capit all, this is happening at the sametime that interest rates have hit anhistorical low - with close to zerorates in Europe and negative rates inSwitzerland, Denmark and Sweden.

Market Picture

These regulatory changes and marketcircumstances have impacted theprofit and loss accounts of banks,forcing a reduction in interest incomeduring the course of the year and aconsequent re-planning of budgets.Transaction banks face a difficultchallenge, particularly in low interestmarkets. Historically and withinnormal market circumstances mosttransaction banking budgets havebeen built around an assumedrevenue split of 70% interest and30% fee split. Thus, negative InterestRates for CHF, DKK, SEK and EUR atzero affects both banks and clients.

• For clients, capital preservation isat risk with negative rates and theaccounting department iswondering how to book thesenegative income and loss ofprincipal amounts.

• Banks are facing challenges withtheir core banking systems as inmany cases they are not entirelyable to deal with negative rates.Most European Banks face highand unavoidable Capexrequirements within their corebanking infrastructure, as a resultof this and many other reasons, ina situation in which interestrevenues are declining.

In this environment, banks becomefollowers rather than front runners.This is evidenced in a high number ofFintech start-ups and a bought rangeof services providers. Thus, banks runthe risk of being arbitraged by theirclients in this challenging negativeinterest rate environment.

None of this changes the need forbanks to attract and hold retail andwholesale deposits in order to fundtheir assets and to be less dependentupon wholesale funding. In such amarket, corporate clients (SMEs) areseeking a favourable rate for theirexcess liquidity. Banks are able toprovide this using an FTP (FundTransfer Pricing) which is higher clientremuneration than market rates forcertain savings accounts and clientgroups to encourage these clients todeposit their funds and moreimportantly to leave and or evencommit these funds on the bank’sbalance sheet. The FTP makes use ofthe low volatility of a large portfolio ofmany clients with small tickets. Thelower the volatility of a certainportfolio is the longer this portfolio

may be replicated on the yield curveresulting in higher performance of thetotal portfolio.

So what is happening?

Banks must seek stable funding, andreserve assets to meet the newliquidity requirements in the form ofHQLA (High Quality Liquid Assets).Thus, the less the volatility of clientdeposits becomes the more value thebank ascribes to these deposits.

This is also the rationale behind theLCR (Liquidity Coverage Ratio) ofBasel III which is designed toincrease the short term resilience of abank. The more stable the depositsare, the less the chance that depositsare called. The LCR provides liquiditybuffer measures per client group ofthe chances that a deposit is calledby its holder in the coming 30 days.For example, a corporate client whichdeposits €15 million with a bank asdaily available liquidity, forces thebank to keep 40% as a liquidity buffernext to possible other reserverequirements.

Thus, banks have to attract depositson a different and more costly basis.The cost of carry is twofold;

• the additional remuneration toattract the depositor;

• and the cost of missed opportunity, as the cost of holding higher quality (and less performant) assets within the LCR and the intraday collateral buffers. Today, the return on deposits with central banks in Europe is negative and the return from government bonds is close to zero

As a result, transaction banks arelooking how to price deposits fromdifferent client groups taking theHQLA requirement per client groupinto consideration. Banks arecompelled to seek ways to make theirdeposits less volatile. One way is toensure that the client commits itsdeposit to the bank for at least thecoming thirty-one days. In this way,the deposit is not called for thecoming 30 days and as a result thebank doesn’t have to put expensiveHQLA to it. These deposits are called thirty-one day call deposit accountsand are everlasting till the momentthe deposit is called and it is settled31 days later. In the market, we seedifferent call deposit accounts, some

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with a 31 day settlement and otherswith even 35 days. This is caused bydifferent ways jurisdictions haveincorporate Basel III into local law.There are also banks who offer thison a 90-day basis which makes thesedeposits even less volatile. The 90-day approach complies with the cashand cash equivalent norm of IFRS.

The NFSR put another dimension todeposits. Simply put, it regulates thefact that banks can’t fund their assetsentirely with short term fundingdeposits. For example the €15 mcorporate deposit of less than a yearcan only be used for 50% forfinancing of long term assets. So theNFSR brings in another aspect of howto value corporate deposits for banks.

But banks still also require more HQLAto cover the intraday liquidity peaks.

So they seek new operationalrelationships, which have to be mutually beneficial. This is

described in the diagram below.These relationships involve a deepermanagement of the customersupply chain.

A bank can service all the activities ofa corporate client in the area ofbuying, producing and selling in sucha way that the client is able tomanage its cash better and improvethe value of its working capital. Inthis type of relationship, banks arevery close to their customers, thebalances attracted from these customers are less volatile and areperceived so by the regulators. BaselIII speaks of an operationalrelationship and what we describeabove is exactly this. Corporatebalances attracted on currentaccounts from clients within such anoperational relationship require a 15%lower HQLA buffer compared withclients without. As a result, banksbecome much more selective fromwhom they like to have balances/deposits / funding. This is similar to

what happened with Basel II. Bankswere more willing to provide fundingtowards clients with a lower RWA. Wesee a similar trend within depositgathering. The Basel III liquidityregulations favour fewer and deeperrelationships with clients whichprovide less volatile and small tomedium sized deposits.

Summary

For most Banks unsecured wholesalefunding is still the cheapest way offunding. The cost of HQLA should betaken into consideration. HQLA is notonly correlated with the type of clientand the relationship but also thevolatility of the deposits. Two keyactions are obvious.

• Improve the deposit base. The longerthe client commits balances to thebank balance sheet the higher theirvalue. So banks need to incentivisetheir corporate clients to transactwith them in a mutually beneficialway, minimising the need for LCR.Deposit gathering is still veryimportant but banks are compelledto be more selective.

• Deepen the corporate relationship.Ideally, banks want to extend theiroperational relationships with keyand selected clients to bank theirfull Financial Supply Chain. In manycases, banks are shedding clientswhen this restructuring of thebanking relationship cannotbe achieved.

Whilst there are other methods ofdecreasing liquidity requirements, theabove are the key methods whichtoday’s transaction banks are using tocreate more stable funding, whichcomplies with regulatory direction.