Liquidity: why the big picture may be bigger than ever

 

From sticky balances to balancing relationships, financial institutions (FI’s) need to take a broad view of liquidity to navigate the current climate, explains Richard Brown, Head of Balance Sheet Management, Global Transaction Banking, Lloyds Bank Commercial Banking.

Richard Brown

Head of Balance Sheet Management, Global Transaction Banking, at Lloyds Bank Commercial Banking

Richard Brown

Liquidity is a topic of particular interest for FI’s in the current market. Regulatory changes, particularly Basel III, require banks to strengthen their balance sheets and boost liquidity to protect customers’ cash and ensure that obligations can be met during a stress event. Against this backdrop, it is more important than ever for the industry to ensure it focuses on helping its customers as they navigate the regulatory changes by building strong and sustainable relationships with them.

Impact of the new regulations

Basel III has already had a wide-ranging impact on the financial services industry. Before the financial crisis, there was more liquidity in the market: banks were able to lend to each other more freely and were benefiting from greater short-term liquidity, which could be used to fund the balance sheet. With the arrival of the new rules, however, this has become more difficult, and banks are not necessarily looking to lend to each other in the short term.

From a liquidity point of view, the initial aspect of focus in Basel III is the Liquidity Coverage Ratio (LCR), which focuses on the risks associated with an outflow of cash over a 30-day period. Under the LCR, cash balances which will remain stable during a period of 30 days have greater value for banks than balances which may be withdrawn during that period. As a result, the appeal of short term or volatile deposits for banks is significantly reduced while cash embedded in operational relationships, or contractually secured for longer become of greater focus.

"Given the focus on liquidity as a result of LCR, banks may have to consider bringing in deposits against the overall economic value of the relationship with the client.


Instant access monies with no ancillary products and services are becoming more and more difficult to support, therefore it is important to look at how a bank meets the full range of client needs with a view to embedding the relationship"

Where client deposits are concerned, regulatory change has led to a significant shift in how such balances are valued and rewarded. As well as needing to buy gilts and bonds to cover short term balances during a stress event, many banks are limiting their loan-to-deposit ratio by capping the amount of deposits that they are willing to take in. This is despite the fact that companies around the world have accumulated significant balances that they want to place with banks. This disconnect makes it vital that banks continue an open and honest dialogue with their customers.

Downgrade triggers

The LCR also impacts securitisation deals in which downgrade triggers are included in the terms and conditions – for example, stipulating early repayment or the posting of additional collateral in the event that a bank is downgraded by a credit rating agency. Under the LCR, banks are required to hold 100% of the value of obligations relating to additional collateral or cash outflows that would be incurred in the event of a downgrade.

At an industry level, leverage has also had an impact on the repo markets resulting in a global contraction of these markets and the reduction of a valuable source of funding for banks. This in turn increases the squeeze on liquidity for banks.

The impact of the new regulation has been particularly significant in the US. While the LCR is being adopted around the world, the US has been about a year ahead of Europe in its implementation of the new rules. As a result, banks in the US are already seeing an impact as the value of bank funding becomes less attractive. This in turn has meant that these banks are less likely to hold deposits for their bank clients on an instant access basis.

Relationship focus

These developments have led to a greater emphasis on innovation, as well as on the value of relationships. Banks are having to be more innovative in terms of how they fund their balance sheets and some are looking to tap into additional sectors, for example automotive or technology. At the same time, banks must also balance their own liquidity needs against those of their customers, who are asking how best to manage their liquidity in a market that continues to be characterised by low interest rates and high volatility.

While this can be challenging, new opportunities are arising which can help organisations make the best use of their liquidity. For example, with banks placing greater value on ‘sticky’ account balances under Basel III, clients are able to access new fixed term deposit products which offer more attractive returns by locking in cash for a specified period.

A wider view of value

In the current climate, the ‘big picture’ is arguably bigger than ever, and it is therefore particularly important to maintain an honest and open dialogue about both parties’ goals, requirements and strategies – over the short, medium and long term.

"With downgrade triggers presenting greater challenges under the LCR, it is more critical than ever to maintain an effective dialogue with the ratings agencies"

Products, proposition and price are all key areas in which banks can differentiate themselves, but we would still argue that these should be viewed as secondary to the importance of building robust, transparent relationships between banks and their clients. With downgrade triggers presenting greater challenges under the LCR, it is also more critical than ever to maintain an effective dialogue with the ratings agencies.

Meanwhile, for both financial institutions and non-bank financial institutions (NBFIs), it is essential to approach relationships with correspondent banking partners in a more proactive way during this challenging time. Banks should be initiating conversations with their FI clients about the impact of regulation – but in order to hit the ground running, FI and NBFI clients can take the initiative by instigating meetings, sharing their plans and voicing their concerns in order to build effective and sustainable relationships.

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