Managing cash flow is a new challenge for banks

Recently, stories about liquidity pressures have been all over the news. This is because banks and other financial institutions are feeling the strain of market problems. Even popular companies on the market, like fast-growing fintechs, are feeling the effects of the lack of liquidity.

For years, banks and the economy as a whole have had an easy time getting money because there was a lot of it and it was cheap. But things are changing, and we need to rethink how to control liquidity in the face of rising interest rates, quantitative tightening, and economic uncertainty.

Both wholesale and retail payments are moving quickly toward real-time processing, which has become a buzzword in today’s liquidity landscape. This is especially hard for financial institutions and infrastructures that rely on ways to save money, so liquidity is getting harder to find. Also, the way money is being handled now makes liquidity very hard to find and expensive.

Because of this, the topic of intraday liquidity has become much more important to banks, especially global banks that are important to the whole system. Central banks and regulators all over the world are much more aware of how interconnected markets are and how credit and liquidity shortages can spread to other markets and hurt the economy.

What is liquidity management?

Before we talk about how to deal with the problems, we need to know what liquidity management is and how it affects how banks and other financial institutions work.

Simply put, liquidity management is a bank’s ability to pay for its assets and meet its financial obligations without paying too much. The bank’s management team is in charge of making sure there are enough funds to meet the needs of both depositors and borrowers. To deal with liquidity problems, banks must keep enough high-quality liquid assets (HQLA) and have access to borrowing lines and other ways to get money. The goal of intraday liquidity management is for banks to have the funds they require when and where they require it, without having idle funds on their balance sheet.

There are three main parts to liquidity management that should always be at the center of a bank’s plan:

Getting granular and timely visibility: Banks need to have access to data where they need it, giving them a clear view, both at a granular and intraday level, of positions, payment obligations, cash, and funding balances across all relevant accounts and relevant legal jurisdictions and entities.
Having a truly global approach to operations: Every bank is at a different point in this regard. Having truly global operations is important to allow integration across all activity across all business units, which gives a clear picture of how needs from every part of the bank affect liquidity positions. This lets the Treasury, Payments Operations, Global Markets, and other business units work closely together with the help of core technology.
A focus on analytics: In the past, banks mostly looked at analytics from a regulatory point of view. While regulation is still a top priority for all banks, they are paying more attention to using analytics to solve their core business problem, which is how to optimize their global payments activity to be liquidity efficient while also meeting other constraints, like customer payment expectations and individual financial goals.
But the current economic problems are changing the game and putting a new set of challenges in front of financial institutions and infrastructures as they try to improve their liquidity efficiency at a time when there is a big push for real-time processing (QT).

How the current state of the market affects things

You can’t get away from the ongoing economic and cost-of-living crisis, and many people are feeling the effects. Inflation has caused central banks around the world to raise interest rates. The U.S. Federal Reserve just did this again at its last meeting of 2022, and the European Central Bank and the Bank of England did the same soon after. These rate increases have a direct impact on the margins and growth of banks.

Since lending is what a bank does best, a rate increase means that their net interest income (NII) from loans with an adjustable rate will go up. But at the same time, their customers will want a higher return on their deposits, which could lead to more deposits going to the government, money market funds, or other banks. Then, the change in NII will depend on how quickly assets (loans) and liabilities (debts) are revalued (deposits).

As the cost of funding for banks goes up, these costs are just passed on to the customer in the form of higher lending rates. In 2022, the average interest rate on a mortgage went from around 2% to over 5% in less than a year. This hurts banks’ growth because these mortgages are unaffordable for both new customers and existing borrowers who are either on variable rates or are due to renew in 2023. This affects the housing market’s loan-to-value (LTV) ratio and causes mortgage default rates to rise.

Because of this, banks have no choice but to rethink how they handle liquidity.

The parts of a good liquidity management plan

First, banks need a real-time view of all of their assets and obligations. This is called “data centralization,” and it works well. Most banks have trouble getting the whole picture. Second, once they have this real-time granular view, they need to be able to evaluate this information in the context of their business goals, such as any cash and capital restrictions and projected cash movements over the next day, week, or month. Third, once these basics are in place, it’s time for them to act, and this is where newer technologies come into play. When it comes to these kinds of solutions, banks need to think about two things: interoperability, or what can work with their current systems and payment rails, and extensibility, or how to build real-life workflows within their current system while adding new technology. This is where the chance to use APIs and automated workflows to improve processes becomes a real possibility.

There are two major factors that affect liquidity management right now. The first is the push for a world that runs in real time. Everything, whether it’s retail or wholesale, is now expected to settle right away or at least much faster than before. This push for real-time payments is bringing the industry together and affecting every part of the payments ecosystem. This is especially good news for end users. But when it does that, it puts a lot of pressure on banks and the rest of the financial supply chain to handle liquidity well.

The second force is the simple fact that quantitative tightening is happening at its fastest pace in decades. Given how quickly this tightening cycle is happening, it only shows how important it is for participants and the financial system as a whole to save money on liquidity. We can measure this by looking at how the environment has affected services like CHIPS, the largest private sector USD clearing system in the world, where both volume and value are up 4%. There is a clear positive cycle in which the volume of CHIPS tends to increase liquidity savings and efficiency. This is because of the fast-changing environment we are in right now.

Finding a solution to the liquidity problem

The first step in solving any problem is to be able to see what’s going on. There are many reasons why people are using more cash and many ways to fix these problems. So, keeping this in mind, if banks want to deal with rising interest rates and lower their overall operational costs, they must first understand how money is moving through the banks right now. To do this, they have to look at the cash flow characteristics, structure, and stability of each major asset and liability category to see how it affects operating and contingent liquidity risk. This assessment, along with an evaluation of how these asset and liability accounts affect each other, gives us a way to figure out how much liquidity risk the institution has.

Another important part of managing cash flow is figuring out what money is needed for operations and what money is not needed for operations. This is significant because, following the financial crisis of 2007–2008, the way banks are regulated in terms of deposits has changed. This is done by looking at how often the client uses the money to pay bills. By looking at the balance between operational and non-operational money, the bank will be able to better manage liquidity so that, for example, they can lend money to the public while keeping enough money to make payments on their clients’ behalf. When it costs more to get cash, these operational deposits need to be equalized.

As the answer, technology

When faced with these kinds of problems, banks must be ready to use technology. As a leader in deep technology analytics, we think that the key to solving intraday liquidity management lies in a few key technology components.

The first is the centralization of data, which includes everything from global data lakes to keeping data in core operational systems. The second is regulatory reporting and metrics, and it’s exciting to see a mix of new market entrants and companies that have been in the industry for a while bringing technology-powered solutions to the market. Third, there are a lot of core operating technologies, like workflows, that integrate with payment systems and ledger insights. Lastly, analytics, which is what we do best at FNA, is putting more emphasis on simulation technology to organize and optimize payments to reduce liquidity costs. The market is benefiting from our track record of helping treasury and liquidity teams optimize their liquidity by using network visualization, analytics, and simulation technology.

Banks have a huge chance of solving the liquidity problem if they use real-time data and smart algorithms that are built into payment schedulers and payment gateways. Also, banks can become stronger by getting early warning of market stress and changes in how customers pay, as well as by being able to handle these things.

Large banks used to be able to lose between £100 million and £200 million per year in liquidity costs without affecting their bottom line. But times are changing, and banks need to change too.