3C AdvisoryControl • Capacity • Cost

September 2012

Liquidity in BanksAn Inconvenient Truth

REAL WORLD

Government action has to be taken to control a n d s e c u r e s u c h precious dwindling water stocks. T h i s a c t i o n i n c l u d e s educating the population in order to change their habits, improvements to the inf rastructure and f i n a n c i a l l y p e n a l i s i n g those who don't comply

THE CITY OF LONDON BANKS

All firms are focusing on t h e o r e t i c a l l i q u i d i t y m o d e l s o f w h a t t o measure, how to report, how much extra it will cost them, etc. very few seem to be considering how the base liquidity r e q u i r e m e n t s c a n b e mitigated

Banking is not different from the real world: Liquidity is scarce and increasingly expensive. Few, if any, firms seem to be considering how the base liquidity requirements can be minimised and tightly controlled. We think that banks need to adopt the practices of the real world and invest in the infrastructure:

Educate. Ensure that all staff appreciate that cash is a valuable commodity and needs to be treated as such. Fix the infrastructure.  Stop all leaks in the system. Understand where the leaks and weak points might be and stop the wastage is occurring.Charge. Allocate the costs to those who really drive the usage. This will encourage the right behaviour

Taking the initiative to fix the infrastructure will begin the education process. In the past, the eco-system the banks work within has been quite forgiving; there has been plentiful and free intra-day liquidity and credit provided by the Nostro or correspondent banks. Profit margins have been good. This has helped the process inefficiencies stay undetected, or at least unimproved, and keep the level of desire to fix them low. Across the industry, there is undoubtedly a focus on the Liquidity Buffer; this applies equally to credit providers, the Nostros and Self-Clearers and to credit users, those who use a Nostro for their payments. There is a un-holy trinity of changing regulation that has a single common denominator; liquidity and cash flow. Real-time. The formal regulatory guidance requires a degree of intra-day control and oversight that is not present in most firms. We expect that more and more correspondent banks will charge for intra-day liquidity, so whether driven by cost or regulation, banks will find they have to able to track cash flows in real-time in order to work within credit limits and minimise liquidity costs.

LIQUIDITY IN BANKS: AN INCONVENIENT TRUTH SEPTEMBER 2012

Water is for people what liquidity is for banks; their lifeline. We have seen the devastation and drama that water shortage can bring in almost every location. Recently we have seen similar problems albeit on a much smaller scale in the UK. Liquidity is the lifeline of the world's financial institutions. We have seen the devastation and drama that a liquidity shortage can bring to over-stretched firms such as Bear Stearns, Morgan Stanley and the ultimate downfall of Lehman Brothers.

Regulators globally are focusing on ensuring optimal & plentiful liquidity is available in order to avoid systemic failures amongst the many participants of the financial markets. Tighter rules, complex reporting mechanisms, ensuring ever greater liquidity buffers are retained. This is all about measuring according to the rules and having enough liquidity, or in the jargon of the day HQLA, high quality liquid assets, to comply with the rules. The price of doing business is going up. The revenues are stalling.

We would offer the opinion that the focus is too narrow. All those Basle III are must do things. Lots of math. What is being neglected is the plumbing.

LiquidityRules

Basel Rules on Intra-day cash balance management

Basel Rules on FX Settlement Risk outside

CLS

The Un-Holy Trinity: new rules proposed by the Basel Committee on Banking Supervision mean force banks to be very precise in their cash management or face a massive burden of extra charges

OUR APPROACH

Financing the assets in the Liquidity Buffer can cost 150 bps or more. We believe that banks need to widen their focus to look at how liquidity is being consumed, where

today thy are mainly focussed on what is required. To illustrate this, take the key Liquidity Coverage Ratio (LCR). This requires banks to have enough assets relative to requirements to meet the test. That puts the focus on simply measuring and then ensuring there are enough assets to pass the test. Our belief is that banks can actually reduce the flows, reducing the denominator and allowing themselves to reduce the assets, the numerator.

Our approach is to work from the outside in. What are the real cash flows in the real world? Which ones can be eliminated or reduced.

Working backwards allows for a firm-wide view of where change is needed and will lead to lasting process discipline. Through process change and the resulting better control, capacity can be increased and other costs reduced too. What is required is a cross asset class approach looking both in the product silos, such as FX or Bonds, and in the core or shared functions such as payments and Network Management.

The small team of experts interested in this work each individually completed well over 10’000 hours in these fields. They have worked in various firms and through many business cycles. There is a shared understanding of the key factors for success here:✦ The basic disciplines that are necessary to enforce in

order to “get the plumbing right”✦ The current regulatory environment and its

imperatives✦ The institutional factors that often divert firms from

actually executing the strategy that is needed to implement the right set-up

These examples are from actual practice. They show how focus o n k e y a r e a s c a n translate to meaningful reductions in liquidity needs and actual costs.

What we have seen is a general picture of poor process management. Multiple areas process the same product in different ways, different entities have different banking and custody arrangements, trades are booked late even though they need not be and there is little or no awareness of the impact of the process on cash flow in the real world.

To date, the banking environment has been forg iv ing; fa t profit margins have allowed poor process to persist. With those margins coming down and the regulatory demands i n c r e a s i n g , t h e environment will be less forgiving.

USD9B

Calculated Amount for FX

3B

Actual Need for FX

-67%

Real vs Calculated Need

The math calculation demanded 9B. By looking at what was actually being used in the real world and tightening up internal discipline, one Investment Bank was able to reduce this figure by 67%. And that before really changing behaviour.

-25% -50% +100%

Gross Payments to Third Parties

Gross Payments Inter-Company

In-House Payments

Reducing Gross Payments

Over 3 years a major bank used netting to reduce gross flows, externally and internally and made use if its own bank to service group companies. Together this reduced the payments moving in the real world by $100B per day.

MAKING AN IMPACT

Share of payments that is inter-company

Saving Payment Costs

For a second tier investment bank some 40% of all payments are inter-company. Internalising those and netting them to a single movement per currency per day offers the potential to save $1.5 million per in fees per year

40% > USD1.5mm

Savings potential thru internalising

LIQUIDITY IN BANKS: AN INCONVENIENT TRUTH SEPTEMBER 2012

LIQUIDITY IN BANKS: AN INCONVENIENT TRUTH SEPTEMBER 2012

Interest?

If you would like to talk with us about this topic, please call or e-mail us.

Olaf Ransome

olaf.ransome@3CAdvisory.com

+44 7792 813 091

www.3CAdvisory.com