Growing pains

The liquidity challenge for the challengers

Daniel Lempke

By: Gavin Daniel, Daniel Lemcke
Blog

There are many challenges for any firm questioning conventions in their market – as the challenger consultancy, we understand this better than most. For a challenger bank, maintaining their Liquidity Coverage Ratio (LCR) above 100% as they grow is one of the more important, but also most overlooked and underestimated, of these challenges.

I’ve heard of capital ratios and reserve requirements, but what is LCR?

The Liquidity Coverage Ratio is part of the global regulatory framework Basel III. It states that a bank must hold enough High Quality Liquid Assets (HQLA) such as government bonds or cash to cover their net cash outflow over a 30 day period of stress.

Now, no one likes a blog with an equation, but this one for calculating the LCR will help (I promise):

To meet the regulatory requirement, LCR must remain above 100%. Although we do see some banks targeting a slightly higher level (depending on their risk appetite).

Surely this is a problem for all banks?

Managing liquidity is, of course, something that all banks must do. However, the way that LCR works spells triple the trouble for rapidly growing challenger banks. Why?

Problem No.1

A common challenger bank strategy is to start by building a strong base of deposits. They then move fully into lending products such as mortgages and loans. Unfortunately, this causes a problem for the LCR. This is because we must model a ‘significant stress scenario’ for deposits leaving the bank (outflows) but do not yet have a base of committed incoming funds such as mortgage repayments (inflows). This means that the net outflow is high and LCR tends to be low.

Large, established banks, on the other hand, have strong lending portfolios which generate ‘guaranteed’ inflows.

Problem No.2

A large bank will have an established history with their customer base. They can use this to draw conclusions about how they would behave in a stress scenario. The LCR rules allow them to factor these forecast behaviours into the inflow and outflow calculations.

A new challenger bank on the other hand, does not have this history. It is forced to take the most conservative assumption (high outflows and low inflows).

The way that LCR works spells triple the trouble for rapidly growing challenger banks

Problem No.3

Either of the problems above could be solved by taking out a loan on the wholesale markets and/or restricting supply of the ‘offending’ product. However, these responses are likely to impact profitability and/or capital ratios. Both of these metrics are already highly stressed in a rapidly growing challenger bank.

The wholesale funding option assumes it is even possible to access loan markets as a startup bank without an established brand and borrowing history in wholesale markets.

So we just have to accept more capital and lower profits, right?

Not necessarily.

By altering product design and phasing rather than product mix, challenger banks can actually improve the LCR position without destroying their profitability or capital position.

Lever 1: Increase the proportion of savings that are fixed term – the longer the fix, the better.

With instant access savings, the full balance is eligible for withdrawal in any given month. This weighs heavily on the outflow part of the LCR calculation. However, only a proportion of a fixed term savings balance would be eligible for withdrawal in any given month and is treated more favourably.

Lever 2: Give customers sensible credit limits

When we calculate the LCR we need to take into account the possibility that people will use up credit which is committed but not currently used, like maxing out a credit card. This means that if customers have large credit limits which they do not use then we see a large outflow value in the LCR equation.

To solve this, customers can be given credit limits which are just above their usual spending habits. Doing so could significantly reduce the outflow associated with unused credit limits without negatively impacting the customers themselves.

Lever 3: Grow the mortgage book with care

For LCR purposes, the value of mortgages which are to be extended in the next 30 days (a cash outflow) are extremely important. This means that a fast-growing mortgage book will pull down a LCR.

This can be combatted by starting to offer mortgages earlier, when capital and HQLA are likely to be plentiful. This allows the book to grow more slowly without changing the overall number given out.

Other types of retail loans work in a similar way but because they are much smaller this lever tends to be less effective.

“By altering product design and phasing rather than product mix, challenger banks can actually improve the LCR position without destroying their profitability or capital position.”

So I can have my cake and eat it?

By being smarter with product structure and phasing rather than altering product mix, a solution specific to an individual bank’s product mix, customer base and business strategy can be designed. We have worked with both established brands and challenger banks to do just this.

As the challenger consultancy, we understand the growing pains that come from successfully disrupting the status quo. We understand how difficult these pains can make it to get on with growing a successful business and the importance of removing as many of them as possible.

Our advice for challenger banks? Don’t let LCR be that growing pain, find a smart solution and get on with growing your business.