Banks are facing a “new liquidity reality” due to global economic fluctuations

By Phillip Straley, President of FNA

The way in which banks approach liquidity management has changed on a fundamental level.

Think back to the time before the global financial crisis of 2008, when sizeable profits kept banks in comfortable, lucrative positions. Banks were never very good at managing liquidity risks, simply because they didn’t need to be. They could leave piles of money on the table and still be generating 25% plus returns on equity.

Back then, liquidity was cheap. There was still the requirement to uphold some basic management and reporting requirements, but the regulatory risk to not doing better was low. This changed – albeit slowly – over the decade post financial crisis.

Now, everything is different. Changing conditions are demanding a rethink to re-establish control over liquidity in the face of rising interest rates, quantitative tightening and economic uncertainty. Liquidity is now scarce and costly, and this requires a change in mindset and handling by banks.

Why is liquidity more important now?

Liquidity management is a bank’s ability to fund assets and meet financial obligations without incurring unacceptable financial costs. Essentially, it’s the task of having money when and where you need it, without excess idle money sitting on the balance sheet.

The fundamental issue is that liquidity costs are rising, which requires banks to pay greater attention to the way liquidity is managed.

A primary cause is increasing central bank interest rates, which ultimately set the benchmark for liquidity in general. This has meant that structural liquidity is equally more expensive, meaning higher interest rates on corporate and consumer deposits. As banks’ own funding costs increase, these are passed on to the customer through increased lending rates.

Further, intraday and overnight rates between financial institutions are impacted, though not necessarily all in the same way, meaning liquidity takes on an even higher premium.

The impact of an economic downturn

The direct impact of inflation, affordability issues, and a rising cost-of-living takes the form of increased credit problems for individuals as well as companies, particularly SMEs.

For most banks, this has not yet led to large defaults or credit charge offs, but we can expect this to worsen throughout 2023. In fact, we’ve already witnessed the start of increased credit provisions for expected losses.

There is a first level benefit of rising interest rates for bank profitability, as rising interest rates are generally good for earnings. Banks are able to re-price loans quicker than deposit rates.

However, this may be quickly replaced by negative headwinds of credit losses as provisions rise over the next 12-18 months.

With times getting tougher, we’re seeing greater corporate earning issues. Banks are now in a position where they’re looking out at the market and seeing less creditworthy borrowers. Banks therefore have two options: they can take more risk, or become more risk averse.

Given the uncertainty around how long the current quantitative tightening will last – which could be as long as another year, or more– it’s clear that banks need to become more cost efficient.

What can banks do?

There are three core areas that banks should focus on to tackle liquidity management.

Visibility

A fundamental challenge that banks face is a lack of visibility into their liquidity.

The first step is therefore to conduct an evaluation of the cash flow characteristics, structure and stability of each major asset and liability category to determine the impact of liquidity risk. Understanding the distribution of liquidity risk across the business fills the gap left by years of opacity.

Armed with a granular view, banks must assess the information in the context of their business objectives, such as cash and capital restrictions and projected cash movement.

Funds classification

Next is the need to differentiate between operational and non-operational cash, which rose to pertinence after the 2008 financial crisis when changes were made to the way that banks must evaluate the deposits they have, and as liquidity reserve requirements rose. This assessment allows banks to better manage liquidity to strike the balance between lending to the public and preserving funds to make payments on behalf of their clients, and to meet liquidity buffer standards.

Technology

Finally, banks must recognise the role that technology plays in improving liquidity management, which can be broken down into three key areas. The first is data centralisation, from a global scale to core operational system maintenance. Next is regulatory reporting and metrics, and recent years have witnessed an exciting combination of new market entrants and industry incumbents introducing technology powered solutions to the market. The last element is analytics, with a greater focus on simulation technology for organising and optimising payments to reduce liquidity costs.

The new reality

There is a huge opportunity for banks to adapt to the new liquidity reality by bringing together real-time data and smart algorithms, integrated into payments schedulers and payments gateways.

Beyond optimisation, resilience is also key. In particular, banks can enhance their durability by monitoring the early warnings of market stresses and changes in customer payments behaviours.

We cannot avoid the reality that liquidity is becoming more expensive. Banks’ income statements are therefore going to be put under huge amounts of pressure, meaning saving liquidity costs is becoming critical for bank profitability.