Armin Widjojoatmodjo assesses the challenges liquidity managers face in preventing a stress situation from occurring.

Under normal business circumstances, liquidity is always considered to be available. However, there is always the worry that liquidity may dry up. It is the task of the liquidity manager to ensure that a firm is able to meet the demand for liquidity.

For both corporates and financial institutions, this rests on the ability to refinance when obligations are due. The funding can come from either committed standby facilities (mainly for corporates), liquefying assets (selling, repo or pledging) or, ideally, from new funding sources. Appropriate forecasts of inflows and outflows are necessary to manage liquidity on a day-to-day basis.

The challenge any organisation faces in relation to liquidity is its ability to meet a stress situation; here the paths of banks and non-banks deviate. The classic role of a bank is to provide liquidity to the community. Banks in turn have to rely on the lender of last resort, the central bank, in situations where other banks cannot provide liquidity. When general funding is not available in a stress situation then liquidity is trapped.

Trapped liquidity

Through liquidity directives, regulators try to ensure that the banking community has sufficient spare liquidity to meet an increase in demand. For banks with an international footprint, this leads to ‘trapped liquidity’. To meet local regulatory requirements, banks have to set aside liquidity locally. This increases the cost of liquidity, affecting products such as payment services, loans and customer funding. It may even lead to a situation at a consolidated level in which liquidity is available but it is prohibited to transfer this liquidity to the unit that needs it. This may deepen the crisis rather than solving it.

Global approach

In an environment where markets are connected and create a global virtual market place, this local approach from regulators is outdated. There are currently no harmonised rules on liquidity management within the EU; however, some financial services products, such as debit card and bank payment services, require harmonised pricing. From this perspective, nothing can be done other than organise the process as efficiently as possible, given local constraints.

Central banks have recently urged banks to reduce the settlement risk in foreign exchange deals (for example, having paid Japanese yen early in the day and having to wait for the counterparty to deliver US dollars later in the day). Through continuous linked settlement, this settlement risk has been significantly reduced but liquidity risk has been created. In principle, a failed payment in Australian dollars may prevent the settlement of a euro leg, exporting a local problem to other countries.

To avoid this banks would have to have an almost online awareness of the status of outgoing and incoming payments, and to create sufficient intraday funding to ensure continuation of its outgoing payments. This again requires additional liquidity that needs to be financed and warehoused via the balance sheet, causing the cost of liquidity to increase on a day-to-day basis.

Buffer creation

The strategy for creating liquidity buffers to withstand a liquidity crisis is relatively easy. All that is needed is to create a sufficiently large portfolio of liquid securities that can be pledged at a central bank. The challenge is to assess the appropriate size of this buffer. The buffer then increases the balance sheet, providing a funding profile that is in line with the hypothetical crisis. A large buffer is expensive and a buffer that is too small is useless. The best practice is to run specific scenarios and to calculate the liquidity consequences on the balance sheet.

Based on this analysis, senior management can then decide the size of the liquidity buffer. For banks that are internationally active, this poses the question of where to create the liquidity buffer. To create the buffer at a central level is the most efficient tactic, but it may take a couple of days to liquefy a euro-denominated buffer and turn it into local Indian rupee. Hence some local buffers are required, again increasing the costs of liquidity.

This takes us back to the beginning of the article: liquidity can be managed but it comes at a cost. In the current environment, liquidity seems to be abundant and there appears to be no need to make upfront cost. A financial institution should build up its buffers when it is relatively cheap to do so and ensure that the price of liquidity is reflected in the products. The price of liquidity can be extremely high when it is missing.

Armin Widjojoatmodjo is senior vice-president group asset liability management, ABN AMRO.

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