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What is liquidity management?

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The pandemic is having a deeply disruptive effect on the way individuals and organisations work, and banks are having to reconsider how they can best meet their obligations to customers, staff, and regulators. To succeed in navigating the financial turmoil created by the pandemic, one area banks need to look at carefully, is the way they manage cash and liquidity.

But what does effective liquidity management look like, and how can firms successfully manage their obligations?

 

What is liquidity?

Liquidity is used to understand how easily an asset can be bought or sold without affecting its price, also known as market liquidity. When an asset is in high demand, there is high liquidity, so it will be easier to find a buyer (or seller) for that asset. Cash is considered the most liquid asset as it is very stable, readily accessible, and easily spent – therefore, cash is often used to gauge the liquidity of other markets.

What does liquidity mean in financial institutions?

Liquidity is a bank’s ability to meet its payment obligations without sustaining unacceptable losses. Liquidity risk refers to how a bank’s inability to meet its obligations (whether real or perceived) threatens its financial position or existence. It can also allow financial institutions to understand funding, borrowing, and lending requirements across various time frames, from the highest level down to the individual transaction – by utilising this information, the treasurer then has greater confidence in making funding decisions.

Why is managing liquidity so important?

Proactive management of liquidity is not just a question of meeting regulatory requirements, but a necessity and business imperative in today’s increasingly challenging economic environment. Global FX volatility is having an impact and capital is more scarce. As such, banks must keep down funding and liquidity overheads and reduce regulatory costs. Proactive management of liquidity means firms are less likely to have the need to maintain high liquidity buffers, incur unarranged overdrafts or make unnecessary use of collateral.

What are the challenges when managing liquidity?

SmartStream’s research shows that many financial institutions still rely on a combination of spreadsheets, emails, and phone calls, as well as manual gathering of information needed from various accounting software and core banking applications, to manage cash and liquidity. Re-engineering systems to achieve a clearer picture of liquidity can, however, be complex and time consuming. Where financial institutions lack an accurate, timely view of their liquidity it can result in added overheads and missed opportunities.

Pressure from regulators is also forcing firms to rethink the ways they monitor and manage liquidity. Following the financial crisis, regulators turned their attention to banks’ management of intraday liquidity risk. They focussed, initially, on the monitoring of intraday liquidity risk but November 2018 saw the European Central Bank publish guidelines calling on financial institutions to strengthen internal capital and liquidity assessment processes: regulators wanted banks to not simply track intraday liquidity – but manage it effectively.

What is intraday liquidity?

Intraday liquidity is the capacity required during the business day to enable financial institutions to make payments and settle security obligations. Firms need the ability to meet these commitments – not just at the end of each day, but any point throughout. The financial crisis of 2008 highlighted the need for banks to improve their liquidity risk management, which includes the management of intraday liquidity risk. The FSA’s liquidity regime included intraday liquidity as a key risk driver and required that banks calibrate their liquid asset buffers considering their need for liquidity intraday, in both normal and stressed circumstances.

The importance of intraday liquidity stress testing

In response to the coronavirus pandemic, financial authorities in several jurisdictions have deferred, but not done away with, BCBS 248 intraday liquidity stress testing. Yet, the pandemic and the turbulent conditions it has created, has made this type of stress testing more essential than ever. Banks must now ask a greater number of ‘what if’s’ in order to identify threats and counter possible liquidity crunches. Credit risk is increasing with direct impact on a bank’s liquidity. The ability to model the potential impact of such occurrences is no longer simply a regulatory box ticking exercise, but a matter of self-protection – and even of survival.

How does a firm meet its intraday liquidity management objectives?

Carrying out a stress test – defining its scope, gathering data, and running the test can take up to eight weeks, as well as requiring a large team and a good deal of manual effort. The cumbersome nature of the process makes running ad hoc scenarios virtually impossible, preventing a more proactive, dynamic approach to risk analysis. It is important for financial institutions to consider investing in sophisticated real-time technology to track intraday liquidity requirements to provide a consolidated view across all accounts, settlement venues and currencies.

What are the benefits of managing liquidity?

Under these difficult circumstances, banks which have in place an enhanced liquidity management system will find themselves better at managing fluctuating demands on liquidity. Such a system can give banks a clear, up-to-date picture of their liquidity, enabling financial institutions to protect themselves more effectively; for example, by issuing early warnings on excessive changes in liquidity, or by assisting firms to stay within internal policy guidelines and alerting them of any breaches.

Wrap up

  • In response to the global impact of the coronavirus pandemic, banks will need to know whether they have sufficient liquidity to ride out the current storm, which, in turn, means being able to locate and access liquidity when required, as well as detect and mitigate any threats to it. It goes without saying, that this is a tough task – even for the most well-prepared and sophisticated financial institutions.
  • Developed to deliver real-time cash and liquidity automation and reporting, SmartStream’s Cash and Liquidity Management solution creates a single, global view of balances across all currencies and accounts – allowing accurate understanding of funding, borrowing and lending requirements.
  • Additionally, SmartStream’s Intraday Liquidity Stress Testing module allows banks to define and run stress tests on demand, utilising existing data. Its ability to generate risk reports quickly and accurately helps facilitate more informed and timely decision making – allowing financial institutions to be more proactive in their risk analysis.

 

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