Liquidity is an essential resource in enabling banks to respond to their clients’ requirements for faster, more certain and cheaper payment and settlement services. Initiatives such as SWIFT’s Global Payments Initiative (gpi) are moving the dial in terms of the efficiency of cross-border payments - but as the operating model improves, the time available to organize liquidity to complete the payment shrinks.
At the same time, post-crisis regulation puts an ever greater premium on effective liquidity management. Having lived through a period of unprecedented access to liquidity in major currencies due to quantitative easing, the banking community is now anticipating a return to more “normal” conditions as central banks begin to scale down or roll back their QE programs.
The US is furthest along this path. Angus Scott says: “The Federal Reserve’s balance sheet has declined from a peak of USD4.5 trillion in January 2015 to USD3.8 trillion in June 2019 as a result of its Balance Sheet Normalization Program, which started in October 2017. The Bank of England and the European Central Bank have also ended their programs of asset purchases.”
As the availability of central-bank liabilities decreases, private markets will need to fill the gap: banks with surplus liquidity will need mechanisms to lend it to those who require it. However, regulatory reforms implemented since the crisis have reduced the availability of unsecured lending markets, and collateralized markets (such as repo) are expensive in their balance-sheet impact.
The Liquidity Coverage Ratio gets stricter
Post-crisis regulatory reform requires banks to take a far more prudent approach to ensuring that they have access to adequate liquidity. Scott says: “A number of measures address liquidity, including the Net Stable Funding Ratio, which encourages banks to match the terms of the assets and liabilities on their balance sheets, and BCBS 248, which stipulates intraday liquidity monitoring requirements.One of the most important measures is the liquidity coverage ratio.”
In its basic form, the LCR requires banks to have sufficient high-quality liquid assets (HQLA) on their balance sheets to cover their obligations for a thirty-day period in which they would not be able to rely on the markets for funding. However, a number of supervisors - including the Federal Reserve, the Bank of England and the ECB - have adopted a stricter approach as part of the Supervisor Review stipulations under Pillar 2 of the Basel III framework, explicitly to strengthen their focus on banks’ abilities to meet their intraday obligations.
Scott says: “Under its Pillar 2 Statement of Policy, the Bank of England expects the banks it supervises to consider additional factors such as peak liquidity needs over the thirty days, not just the position on day thirty; potential challenges in monetising HQLA in stressed markets; and the possibility that access to FX markets might be reduced. Further, it requires that banks consider not just their contractually committed payments, but also uncommitted payments if not making those payments could damage the bank’s reputation or market perceptions of its solvency. Finally, the Bank of England also expects banks to focus explicitly on intraday liquidity, ensuring they have sufficient reserves to meet their daily settlement obligations, and that these reserves are separate from the reserves held to meet wider liquidity resilience requirements.”
The costs of meeting these expectations are high, and there are also opportunity costs. Another post-crisis measure, the leverage ratio, requires each bank to hold a minimum of 3% equity against its assets on a non-risk-weighted basis, rising to 6% if it is a global systemically important bank (G-SIB). Having to hold large portfolios of high-quality but low-yielding assets in their liquidity reserves prevents banks from deploying their equity to more profitable opportunities.
But this isn’t the end of the story. Domestic infrastructures, typically in the form of the real time gross settlement (RTGS) systems run by central banks, are critical for efficient liquidity management and many are undergoing renewal programs designed, among other things, to increase liquidity efficiency. For example, the ECB is building a liquidity management layer to underpin its three major payment platforms: TARGET2 (its high-value RTGS system); TARGET2-Securities (i.e. T2S, its securities settlement system), and Target Instant Payment Settlement (i.e., TIPs, its retail instant payment platform).
Similarly, the Bank of England, as part of its RTGS system renewal program, is both reviewing the operation of its liquidity-saving mechanism and exploring innovative new concepts, such as functionality to support the synchronization of payments between systems.
Yet, in a global context, even RTGS systems represent sub-systems within the wider network. Scott says: “True optimization needs to factor in the interconnectedness of these sub-networks and the central banks, commercial banks, currencies and HQLA of which they are comprised. We are starting to see this panoptic view emerge. CLS, as the global hub of cross-currency settlements, is one of the bridges that link domestic networks together.”
CLS was established with the aim of mitigating settlement risk in the FX market. Scott continues: “The multilateral netting component of CLS’s payment-versus-payment settlement service, CLS Settlement, significantly reduces the amount of liquidity required to settle each day’s FX business and it also offers a key channel for banks to move funds around to meet their payment obligations in different currencies.”
From the back room to the boardroom
Subject to receipt of any necessary approvals, is CLSNow. Scott says: “CLSNow addresses a number of different requirements from banks. At its root, it is a settlement service that will enable banks to exchange currency positions with mitigated settlement risk on a near-real-time basis. This could support many different parts of a bank’s business, from the treasury looking to secure its position at the end of day, to the capital markets middle office that needs to post variation margin across different currencies, to the transaction bank that needs to fund nostro accounts at agent banks to meet client payment obligations.”
As Scott goes on to suggest, there are various parts of the industry that could benefit from CLSNow. “Mobilizing liquidity effectively for clients while managing it prudently and keeping costs down has significantly increased the challenge and moved it from the back room to the boardroom. If the industry can rise to the challenge, the prize is a financial system that better serves its clients at lower risk to society,” he concludes.