The art of balancing efficiency & liquidity

Are you getting it right?

Daniel Lempke

By: Daniel Lemcke, Asher Winterson

After the global financial crisis, the focus of banks fundamentally changed. Regulations evolved to try and avoid other bank failures, but practices still haven’t progressed to the desired liquidity risk mentality.

Operations Managers don’t have the easiest job – they often suffer ‘Groundhog Day’; each year the same mantra is engrained by their bosses to “reduce costs by more than 5%”. They live in a challenging world where they are constantly charged with doing more with less.

Traditionally, this translates into a short-sighted focus on the implementation of Straight-Through-Processing (STP) initiatives. There is nothing wrong with this – STP reduces risk through the automation of tasks and often results (or at least in theory) in being able to reduce headcount. As an Operations Manager’s success is often defined by the number of Full Time Equivalents (FTEs) and the lack of operational failures in order to achieve the reduced budget. STP ticks all the boxes, right?

Unfortunately not.

Misaligned focus

In the world of geographically spread operations and multi-faceted business lines, banks can easily lose sight of when cash is actually leaving the door. In fact, the pursuit of almost perfect STP often results in the development of behaviours which obscure and bloat the actual settlements of a bank. STP is generated as a tactical ‘point to point’ operational solution. Unfortunately, this lacks the holistic view required to step back and understand the opportunity to reduce real cash leaving the bank. This means that the old adage that ‘cash is king’ can often be at odds with operational efficiency.

“Operations can’t simply be a mailbox or siloed business division mindlessly ‘processing’.”

A focus on liquidity for banks is not a new concept – these rules and guidelines have existed for over a decade. Banks are required to manage their liquidity (or cash) to ensure they don’t suddenly find themselves without the available cash in the right place to settle their obligations. It turns into a vicious cycle based on trust, with many international banks relying on other banks to help fund and access other currencies or markets. These are referred to as agent or clearing banks.

Once clearing banks sense that another bank might be struggling, they naturally try to reduce their exposure to protect their own shareholders. It is at this point that bad turns to worse. Beyond each bank reducing exposure (aka, withdrawing credit) there is a strong possibility that they will request more collateral or even worse, not make payments until they are pre-funded.

The cold, hard truth is that if banks fail to recognise the importance of liquidity risk management and the impact it can have, they can quickly become insolvent – think Lehman Brothers in 2008…

We live in a world where banks continually demonstrate a cost cutting mentality.

This thrifty mentality often extends to regulatory compliance; compliance in the spirit of the legislation but at the lowest possible effort. Both factors should lead to a clear focus on reducing the very material costs of managing efficient settlements and liquidity, because through regulation like the LCR the bank must hold expensive assets to ensure short-term resilience of liquidity risk.

However, a disconnect remains. Instead of focussing on reducing liquidity usage, operations teams within banks typically remain focused on implementing traditional cost-cutting methods such as STP initiatives, or the larger scale off-shoring and near-shoring of resources. Nevertheless, they are still missing a trick. Operations can’t simply be a mailbox or siloed business division mindlessly ‘processing’. Regulation is rapidly evolving to understand the movements of cash which leaves the bank. As such, regulator’s powers continue to strengthen which results in banks being penalised through expensive asset reserves/ buffers.

Post Lehmans, the regulations are demanding better tracking of settlement activities and credit line utilisation in order to ensure that the activities of illiquid institutions aren’t hidden by their clearing banks. Beyond the regulation, quite simply, the cost of holding excess assets dwarfs the impact of even large-scale operational cost-cutting. In short, there are real savings to be had by proactively managing settlement liquidity over small scale operational efficiency initiatives.

Effective management will lesson the blow

With regulations rapidly evolving, one pivotal change is that banks must fully understand and manage their cashflows. Not managing the balance between these two competing requirements of liquidity and operations can lead to holding excessive assets, fines from the regulator, or worse…

So, I have a problem. What can I do about it?

  1. Change the mindset – recognise that cash out the door is an important metric. The execution or management of this normally sits with operations.
  2. Measure and monitor – traditional KPIs monitor the speed of transaction processing and the frequency of errors. This needs to change to include a range of metrics that provide a view of liquidity management.
  3. Improve – there are many opportunities available to banks to reduce cash outflows, most of which can be supported using a bank’s current infrastructure. This can be a challenge as the benefits associated with improved management of liquidity are not universally understood. This makes proactive management and support from a range of stakeholders an essential driver for change.
  4. Communicate and educate – not just with internal stakeholders but with clients too, as they benefit from a well-managed liquidity mindset.
  5. Benefit – not only can proactive management of settlement liquidity risk be a reduced reliance on clearing banks and risk reduction but also the significant financial cost savings above. These benefits need to be passed to operations and the businesses they support, whether that is through fund transfer pricing or collateral centralisation.

So, although the focus on STP and operational efficiency is something which should be aspired towards, it must be balanced with the very real costs of managing liquidity and settlement obligations. Ultimately, the onus is on banks to determine how they instil a liquidity management mindset into their operations teams and treasury.

Our message is clear, don’t be caught unaware by this imperative – otherwise your organisation may not live to tell the tale.