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Liquidity transfer pricing – current challenges and a way forward

Here are four areas and a process for embedding liquidity management into a bank’s governance to mitigate the risks.

Overview

Before the global financial crisis of 2007-2008, liquidity was taken for granted. The assumption was that funds were always available at no or very low cost. As a consequence, banks lacked strong liquidity practices, and a series of business models - for example, state financing – relied upon the refinancing of long-term assets with short-term liabilities to ensure profitability.

Background
The financial crisis played a role in liquidity risk management and is becoming an important strategic and tactical topic for both banks and regulators. Banks now believe that liquidity can only be obtained at a price, at least for the foreseeable future, and that there will be very few “lenders of last resort” in crisis situations. Liquidity is at or near the top of bankers’ priority lists and may remain there for some time to come.

In December 2010 the Basel committee introduced liquidity standards as a part of the Basel III capital regime, including the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). The effect was to increase banks’ short-and long-term resilience. The LCR addresses whether banks have adequate high quality assets to survive stressed liquidity conditions over a 30-day period, while the NSFR guides banks to adopt more stable sources of funding over the long-term. In addition to these two ratios, monitoring tools to track the diversification of funding sources, encumbrances on assets, and to alter disclosure to supervisors were also introduced as part of the Basel III initiative. The Enhanced Disclosure Task Force (EDTF) also issued additional requirements – generally in line with Basel guidelines – to alter disclosures to market participants.

Findings

A recent study conducted by the Financial Stability Institute, which analyzed 38 large banks from nine countries, showed several shortcomings in the context of the allocation of liquidity costs and benefits. The key conclusions drawn by the study included:

  • Many banks lacked LTP policies and employed inconsistent LTP regimes.

  • Some institutions did not charge liquidity costs to assets and liquidity credits to liabilities.

  • Measuring costs on an average basis does not cover long-term agreements – it penalizes long-term funding and rewards long-term liabilities – and does not take market changes into account.

  • The Financial Stability Institute noted that the most striking example of poor practices identified in the survey related to how banks failed to account for the costs, benefits and risks of liquidity in all or some aspects of their business activities. These banks came to view funding liquidity as essentially free, and to see essentially zero liquidity risk. These banks attributed no charge to some assets for the cost of using funding liquidity, and conversely attributed no credit to some liabilities for the benefit of providing funding liquidity.

Analysis

Over the past two years, there have been several amendments to the way liquidity coverage ratio (LCR) is to be calculated. In January 2013, the Basel committee revised the dates for LCR introduction. While the original plan was for banks to achieve LCR of over 100 percent by January 2015, the revised minimum ratio is now 60 percent as of January 2015 and will be increased in equal increments to reach the 100 percent rate by January 2019. Additionally, the definitions for eligible liquid assets have been loosened by introducing level two assets – such as corporate bonds with sufficient rating – as well as equity.

Essentially these changes have been confirmed in the final implementation negotiations on March 20th. In addition NSFR will just be used for observation purposes and no minimum standard has been set.

While this could ease the pressure on banks, it remains to be seen if the guidelines are adopted by all the other regulators in a uniform manner, as individual country regulators may adopt different standards as well.

Recommendations

While banks continue to work on their capabilities to effectively manage liquidity and risks, there should be strong emphasis on the integration of Liquidity Transfer Pricing into their overall risk strategy.

The Asset Liability Committee or ALCO- is the (liquidity) risk governing body in many organizations. It typically approves the treasury, controlling, risk controlling and reporting policies.

Treasury - To encourage the right behavior and reflect different maturity profiles, banks might consider maintaining a dual perspective when it comes to their Liquidity Transfer Pricing.

  • Liquidity Management: The treasury would manage short-term liquidity as well as long-term funding and apply the LTP approach across the bank. For optimal effectiveness, a bank may want to consider managing LTP from a central department.

  • Interest Management: The treasury function could be tapped to manage the interest structure and hedge interest rate risk, using different instruments such as swaps or caps, as well as managing the term transformation of interests.

Controlling - Another consideration is to have the control function within the organization divide the LTP into ex-ante and ex-post product and segment profitability calculations.

Risk controlling - This function could be made responsible for designing and proposing the LTP system, and reviewing and adjusting the LTP parameters.

Reporting - In order to create transparency into costs and benefits delivered by LTP, consideration should be given to establishing relevant reporting processes with respect to speed and accuracy.

Authors

D. Kapffer is a managing director within Accenture’s global Risk Management group and is based in Germany. Kapffer has 20 years of experience in the financial services industry and risk management. He has held numerous consulting roles primarily in the finance and risk areas as well as in the financial services industry as head of operations for a wholesale banking division.

G. Hessenberger is a principal within Accenture’s Global Risk Management group, located in Zurich, Switzerland. Hessenberger brings 18 years of working experience in the areas of operational ALM (banks and insurance companies), banking book management and bank controlling, asset and loan pricing, risk analysis and management, as well as asset management.

P. Varadan is a senior manager with the Risk Management group in Chennai, India. Varadan has more than 12 years of consulting experience in financial services and risk management. He has worked with global and regional financial service firms across Africa, Asia Pacific, Europe and North America to transform their businesses and risk capabilities.

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