Treasury Management: Liquidity, Funding, Risk

The central management of funding, liquidity, capital and foreign exchange exposures in a global operations bank come under the preview of its Treasury.  These activities are overseen by a Capital Allocation and Risk Management Committee  or a similar group which generally includes the Chief Executive, Chief Financial Officer, Chief Risk Officer and the Treasurer. Monitoring the Capital Position comprising these activities together with the interest rate risk (which includes defining the risk limits and its monitoring to ensure that the bank is operating within those risk limits) is the responsibility of the the group. Two other important activities for which the Treasury assumes overall responsibility are funding (current and prospective) and exposures to foreign exchange.

1.1         Liquidity and Funding Management

The planning and implementation of the funding and liquidity strategies of a bank greatly enhances its abilities at effective management of potential risks on these vital areas. This includes timely adjustment of liquidity and funding levels to tide over stressful times. A bank’s liquidity and funding profile should portray its overall operating environment including the business activities, markets, strategies and its risk appetite. The Global Trust Bank (GTB, changed name to posit in this article), a well-known global bank with operations in USA, and parts of Europe and Asia maintains a ratio exceeding 100% with regard to its available stable funding to the amount of stable funding required, and this is a good norm for all banks to follow. This standard is known as the NFSR, yet to be introduced under Basel III.

1.2         Liquidity Risk Management

Market events and/or issues specific to a particular bank may generate stressful periods for it. A bank’s liquidity and funding policies should be so geared as to ensure the availability of funds to meet all obligations especially during these times. This could be achieved in the short term by maintaining a buffer composed of cash and highly liquid securities to adequately address any unexpected needs arising for short term liquidity. For long term requirements, adhering to a conservative asset/liability management strategy is considered key. The strategy should comprise maintaining a funding structure aimed at carrying cash reserves well over its non liquid assets with long term wholesale and stable deposit funding.

For instance, as an appropriate measure for managing liquidity risks, GTB carries unsecured long term debt and liquid assets at very much higher amounts than is required for regulatory requirements for funding the business under normal circumstances. This has resulted in an overall increase in its liquidity and funding costs. For monitoring its liquidity position, the Bank uses a measure that it calls the “liquidity barometer”. This is a very useful tool for managing the time horizon over which the adjusted market value of unsecured assets (including cash) may exceed the aggregate value of contractual outflows comprising unsecured liabilities plus a moderate estimate for anticipated contingent liabilities. Thus, the barometer forms a key component of this Bank’s framework for its liquidity risk management under which it’s systematic market stress and bank specific scenarios are modeled. Modeling of additional stress events and liquidity measurement tools further supplement this framework.

Some of the BCBS (Basel Committee on Banking Supervision) based stress assumptions applied by the GTB on its Balance Sheet include:

• Long term debt credit ratings subjected to a 2 notch downgrading (although BCBS liquidity framework downgrades by 3 notches). This necessitates additional funding for requirements that could arise from (off balance sheet) contingent commitments including commercial papers, conduits and draw-downs on unfunded liabilities such as credit and liquidity facility commitments to clients and  enhanced collateral required for supporting derivatives contracts.
• Possibilities of non-availability of Capital, CD and CP markets; and the possibility of declining accessibility to other money markets.
• Likelihood of having to provide non-contractual liquidity support at times of market stress. This could include purchasing back one’s own unsecured debt.
• Ensuring availability of secured funding, this, depending on the collateral type, would be subject to a major amount of over-collateralization.
• Possible large scale withdrawals from deposits of private banking clients.
• Prospect of specific categories of assets such as emerging market securities and real estate loans becoming ineligible for secured funding.
• Possibility of losses in funding values of unsecured assets.
• Probable cash outflows related to the prime brokering business.

The Bank has a liquidity contingency plan to be activated at times of severe liquidity crisis. The specific actions contemplated in the contingency plan include a plan of detailed communications for investors, creditors and customers. The Bank updates its contingency plan at regular intervals, which consists of specific actions to be taken broadly categorized under 3 clearly defined stages as follows:-

• Stage 1 – Market disruption of bank event.
• Stage 2 – Partially inaccessible Unsecured Markets
• Stage 3 – Totally inaccessible Unsecured Funding.

1.1   Funding Sources & Uses

The main sources utilized by a bank for funding the balance sheet comprise its long term debt, main customer deposits and equity capital. A major portion of the balance sheet of a well-to-do bank like the GTB would be match-funded requiring almost no unsecured funding. Match-funding is greatly facilitated where a bank carries assets and liabilities of almost equal liquidity values as well as duration’s when liquidity and funding required or generated are almost equal, so that they cancel out each other. With regard to the settlement of short term liabilities, a bank can draw on its highly liquid assets such as –

• Cash and other dues from other banks and reputed financial institutions.
• Unsecured trading assets that generally form a significant portion of a bank’s total assets, especially assets providing support to the Securities Business comprise securities, collateralized receivables, inventories. Though subject to fluctuations, these assets remain fairly liquid.

A Bank strengthens its liquidity buffer by increasing short term liabilities; say, by issuing CDs which generally comprise the largest share of illiquid assets of a bank funded by its core depositors. Other illiquid assets such as private equity, real estate and other long term investments including a slice off the more illiquid securities may be funded with equity and long term debt subject to maintaining a substantial funding buffer.

Core customer deposits are exclusive of CDs and deposits with banks. Priority is given to increasing customer deposits, as they comprise a stable and flexible source of funding even under stressful market conditions.

The responsibility for the development and implementation including regular updating of a bank’s funding plan rests with the Treasury. A bank’s funding plan portrays its projected growth, future funding needs with maturity profiles, possible effects of changing market conditions and balance sheet developments. In the case of GTB  its capital market debt issuance incorporates a variety of options. They are senior and debt subordinated in US registered offerings together with medium term note programs that include medium term note US programs, Euro market programs and Australian dollar domestic programs. The Bank also has covered bond programs including one in Japan.

Almost the entirety of its unsecured  debt is issued without financial covenants. This acts mainly as a safeguard against sparking off increases in cost of financing and acceleration of maturity of debt. At the same time, it acts as a buffer against possible adverse effects on cash flows, credit ratings, operational and financial ratios and interest payable on long term debt (excluding structured notes). All these activities relevant to a financial institution are managed and monitored based on certain financial indices. The London Interbank Offered Rate is one such index used by many banks including GTB. This term funding approach taken by the Bank reflects the sensitivity of its assets and liabilities to fluctuations in interest rates. As a part of its liquidity planning in the settlement of structured notes, the Global Bank hedges structured notes with positions in the underlying assets or derivatives.

Sample Balance Sheet Funding Structure of a Bank:

(For Illustrating and highlighting Sources and Uses and their implications on a Balance Sheet, additional descriptions and sub totals etc have been brought in; usually not found in a real time balance sheet)

(All amounts are as at year end and are in $ billions)