content Fresh thinking for decision makers

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1 Roland Brgr Stratgy Consultants contnt Frsh thinking for dcision makrs Think your bank can maintain its liquidity vn undr xtrm strss? Fin, but thr's mor to stratgic liquidity managmnt than that Th prcis managmnt of cash and collatral by mans of a markt-drivn incntivs systm And dovtailing with stratgic planning complimnts of th january 2011 Financial Srvics CC

2 From unxploitd opportunitis to futur bst practic Financ Choosing long-trm maturitis can pay off, but it's too risky, right? BANK W now hav vn mor surplus funds. Obviously, that lowrs our margin but is thr any othr altrnativ? Liquidity sprads hav incrasd substantially dos our modl adquatly rflct this? risk managmnt Unxpctd losss occurring du to suddn dposit outflows? This could happn, but is it a major risk? Trasury Rfinancing through Pfandbrif bonds is chapr than through bnchmark bonds. But do w hav nough collatral for th covr fund? Thr's a clar nd for holistic liquidity managmnt hr! A stratgic liquidity position is all wll and good, but if it lads to losss, will it hav a ngativ impact on our crdit businss? Lnding

3 contnt Liquidity Managmnt Banks managing liquidity is much lik driving a car with dfctiv lights in thick fog. This fog can b thought of as unprdictabl markts, which mak it hard to s ahad. Th crash risk is high, bcaus th possibility of insolvncy is playd down and no light is shd on th rciprocal ffcts of th liquidity and arnings positions. Furthrmor, rgulatory bodis hav givn vry littl navigational assistanc until rcntly, and yt st vr strictr spd limits. Th main rason so many banks ar shaky and don't kp thir ys fully opn whn it coms to liquidity managmnt is th truism that says you can only manag fficintly what you ar abl to masur. But on th whol, banks ar not quippd to disconnct th liquidity and intrst rats of an individual position and manag thm sparatly. Th intrnal pricing and allocation of liquidity is thrfor also blurrd and thr ar only limitd opportunitis for incrasing th potntial profit from liquidity maturity transformation whil also complying with rgulatory rquirmnts. Furthrmor, liquidity risk managmnt has not volvd at th sam pac as th othr risk typs includd in th calculation of countrbalancing capacity. Mor oftn than not, risk managrs mak do with kping track of th nt liquidity availabl in various tim buckts and systmatically disrgard th clos tis with stratgic planning somtims with srious consquncs. Whn a bank only has th risk of insolvncy undr control, it can misjudg th srious ffct that cash outflows can hav on th arnings position not to mntion downgrads, rputation damag, and loss of markt shar. SHAKY STEPS Systmatically ignoring profit risks in liquidity managmnt can hav fatal consquncs Problm 1 Banks ar oftn not quippd to considr intrst rats and liquidity sparatly A nw concptual approach dvlopd by Roland Brgr Stratgy Consultants cuts through th fog and sts up stratgic crash barrirs to nsur a saf journy whatvr th wathr. It puts liquidity managmnt right at th hart of th bank's ovrall managmnt, making it a profit cntr that manags this limitd ky rsourc within a highly fficint intrnal markt using a sophisticatd incntivs systm, and also dovtails it with th bank's conomic capital managmnt. Liquidity managmnt is mor than just a complianc function This approach calls for a nw way of thinking, bcaus th discussion on managing liquidity is quit oftn still closly rlatd to safguarding liquidity in strss scnarios. This coms as no surpris whn w look at som of th spctacular cass sn during th financial markts crisis, such as thos of Northrn Rock, Lhman Brothrs, and DSB, which clarly dmonstratd th thrat of massiv cash outflows on th back of a bank's rputation bing tarnishd. Consquntly, intrnational and national banking controllrs ar putting a clar spotlight on th qustion of liquidity rsrvs and how long banks can surviv on how much liquidity. Problm 2 Th amount of nt liquidity availabl is known but how much will it cost to offst liquidity outflows? Th tight ntwork of rgulatory standards was most rcntly xpandd with th addition of th guidlins on liquidity buffrs from th Committ of Europan Banking Suprvisors (CEBS) and th quantitativ targts for th liquidity covrag ratio and nt stabl funding ratio as stipulatd by th Basl Committ on Banking Suprvision. Ths standards can somtims obscur th fact that th topic of liquidity is about a whol lot mor than just complianc. But forsightd bank managrs hav alrady rad btwn th lins of th

4 Roland Brgr Stratgy Consultants 198 bps is th diffrnc btwn on-yar and tn-yar swaps in th uro zon (on January 3, 2011). How can w bst us th opportunitis arising from trm transformation? 256 bps is th sprad of an A-ratd (S&P) US bank bond (with a svn-yar trm) compard with th swap rat (on January 3, 2011). How can you map th risk and liquidity prmium in th intrnal markt modl? nw rgulations and know that thy ar xpctd to thoroughly modrniz liquidity (risk) managmnt and mak it fit for th futur. This modrnization task also manats from th challngs currntly bing facd in th mony and capital markts: Liquidity prics hav skyrocktd in th wak of th financial markts crisis, as can b sn from th stp liquidity sprad curvs. If th only ways for a bank to limit its risks ar with matching maturitis whn rfinancing lndings or rinvsting dmand customr dposits, it will miss out on mor potntial rturns than it did bfor. Convrsly, th yild curv is flat in th mdium to long trm. Convntional maturity transformation, which was onc th main componnt of th intrst margin togthr with th xpctd loss, has thrfor lost som ground to th liquidity prmium. A third aspct is that, with today's crdit sprads, rfinancing through bnchmark bonds or privat placmnts is a sur-fir way to snd th intrst margin plummting. Banks wishing to offr attractiv customr conditions thrfor nd to xploit th potntial of scurd funding, for xampl through Grman Pfandbrif bonds or othr covrd bonds. In turn, this calls for th xtnsiv us of collatral by mans of intgratd collatral managmnt. Basd on th tightr rgulatory stipulations and th dvlopmnt of th markt, th most obvious solution is to s th activ managmnt of intrst rat, liquidity, and crdit portfolio as sparat and individually managabl functions that ar nvrthlss th ovrall rsponsibility of a profit cntr. Dpnding on th bank's businss modl, this ovrall rsponsibility may also b assignd to Trasury/Asst Liability Managmnt. Applying th right incntivs to th intrnal liquidity markt If th liquidity managmnt unit is to mak a significant contribution to th rturn on quity in th long trm, it nds a high dgr of autonomy and th authority to mak dcisions, as wll as a good fit to th businss modl. But abov all, it rquirs an fficint intrnal markt for liquidity that also comprhnsivly taks risks into account. If you ar familiar with th factors that influnc liquidity supply and dmand, and know how snsitiv to intrst rats th various markt modl curvs ar, you ar in a position to us carfully mtrd out incntivs to tip th balanc and gnrat outflows or inflows. THE RIGHT PRICE FOR LIQUIDITY To accuratly manag liquidity by mans of intrnal incntivs, you nd to know what th quilibrium pric is To st th right pric for ach individual xposur, it is ssntial that th intrst rat and liquidity componnts b clarly sparatd. This is a sizabl and costly task but on that soon pays for itslf if th bank in qustion is big nough. By drawing on th markt liquidity sprads on th rfinancing and lnding sid (rcivabls and off-balanc-sht itms), th banks ar abl to manag liquidity supply and dmand much mor accuratly than vr bfor by mans of intrnal liquidity brokrag. Bing awar of th balanc transfr pricing in qustion idally calculatd using a fair-valu modl th Trasury unit can thn implmnt incntivs intrnally to influnc th liquidity inflows and outflows for any priod of capital commitmnt. In this way, th ffct that liquidity maturity transformation has on margins in th nar-trm maturity band can b xtnsivly xploitd if thr is a tangibl incntiv for corrsponding rfinancing activitis prformd according to th limits st, obviously.

5 contnt Liquidity Managmnt Collatral has its pric too Th xampl highlights th fact that systmatically markt-drivn liquidity managmnt gos hand in hand with fficint funding managmnt. Aftr all, th profit cntr can ultimatly xploit arnings potntial only if th rfinancing is basd on mor favorabl conditions than th intrnal liquidity allocation. This calls for th rfinancing sourcs to b valuatd basd on rgional traits such as currncy aras and according to asst catgoris (Pfandbrif bonds, bnchmark bonds, ABS structurs, tc.). It also rquirs a clarly dfind cor procss for collatral managmnt. It is ultimatly th Collatral Managmnt unit's rsponsibility to xclusivly handl th raising and utilization of collatral. In a bst-practic modl, this function is govrnd by th intrnal markt too, and lnding dpartmnts that utiliz liquidity but also rais collatral and thrfor rduc th rfinancing costs hav to b compnsatd. And as is th cas with th liquidity modl, hr Trasury can again us incntivs to influnc th intrnal markt and achiv its stratgic objctivs b it a qustion of limiting th liquidity rsrv, minimizing funding costs, or optimizing risk-wightd assts. Collatral managmnt is without a doubt an intrinsic part of banking. But in ral trms, it is not always clar what collatral is availabl or for which rfinancing purpos it can b usd. Somtims, th sam collatral is vn rronously armarkd for a numbr of diffrnt purposs. For xampl, if scuritis from th covr fund of Pfandbrif bonds ar addd to th liquidity buffr, srious conflicts will invitably aris whn th collatral is ndd. To avoid this, th collatral pool must b clarly idntifid and valuatd, and b subjct to tight controlling, monitoring, and strss tsting. What collatral is suitabl for th covr fund of Pfandbrif bonds and what is armarkd xclusivly for th stratgic liquidity rsrv? What collatral is rpo-ligibl and what collatral will b accptd by th cntral bank with what sort of discount? In all of this, it is important that th various stratgic, oprational, rgulatory and, lgal rquirmnts (for xampl, pursuant to Grmany's rvisd minimum rquirmnts in risk managmnt MaRisk) b takn into account comprhnsivly. In us Buffr Fr Collatral managmnt Not all collatral can b usd for rfinancing. Somtims it is armarkd for othr uss, such as th stratgic liquidity rsrv Liquidity and capital: two sids of th sam coin Banks dsigning thir liquidity managmnt as a profit cntr should at last b awar that such a unit could prhaps also gnrat unxpctd losss at som point. Consquntly, a modrn undrstanding of liquidity managmnt must b accompanid by a rfind liquidity risk concpt. Taking an conomic capital concpt and factoring th liquidity risk out, as is still th convntion, fails to adquatly rflct th actual stat of play, as dmonstratd by th financial markts crisis and th subsqunt rcssion. Vry srious cash outflows can b causd practically ovrnight, for xampl whn ky accounts run into difficultis, rduc thir dposits to zro, and thn draw on thir lin of crdit on top of that. Cash outflows of this kind can oftn b offst only by mans of wholsal rfinancing at unfavorabl conditions.

6 Roland Brgr Stratgy Consultants DOWNWARD SPIRAL OR OPPORTUNITY? 1. Nt intrst incom 2. Balanc sht and profit and loss statmnt 3. Rating 4. Rfinancing conditions 5. Ability to compt in nw businss 6. Chang in markt shar 3 4 This not only dirctly impacts on nt intrst incom (1) consquntly also affcting th profit and loss statmnt, (2) but also rsults latr in th rating agncis downgrading th bank in qustion and its bonds (3) oftn by a numbr of notchs at a tim. This pushs th pric of rfinancing up (4), which in turn ngativly impacts on th bank's ability to compt in nw businss (5) and rsults in ngativ consquncs for th bank's positioning in th lnding and dposits businss (6) and its nt intrst incom in th subsqunt priod. It's a vicious circl, ys, but fortunatly bst-practic liquidity managmnt can just as asily rsult in an upward trnd. Intgratd businss planning should covr risk, liquidity, funding, collatral, and capital aspcts in qual masur (as indd stipulatd by th rvisd MaRisk rquirmnts). A fundamntal lmnt hr is diffrntiatd considration of cashflow, rfinancing, and markt illiquidity risks, and incorporating thm into a holistic bank modl. Historical markt data shows that thr is a corrlation btwn cashflow volatilitis and fluctuations in th liquidity sprads on th rfinancing sid. Th most logical stp is thrfor to incorporat both of ths ffcts into a singl risk modl that ralistically portrays and corrlats bank-spcific risk drivrs and macroconomic shocks. This maks it possibl to manag th liquidity and capital sid of th bank's ovrall risk and th ncssary risk buffrs (i.. liquidity rsrv and surplus capital) using on and th sam modl incidntally, drawing not only on historical data, but also on rliabl forcasts for th mony conomy and th ral conomy. In prspctiv, this corrlation adds th liquidity valu at risk (LVaR) to th liquidity-at-risk (LaR) concpt, thus incorporating liquidity risk into how conomic capital is assssd. Summary: A cas for a rvolutionary planning procss "In summary, w would argu in favor of a much mor comprhnsiv planning procss," says Dr. Ralf Wincklr, Principal at Roland Brgr Stratgy Consultants' Financial Srvics Comptnc Cntr. "Isolatd businss planning is not nough for th forward-looking holistic managmnt of largr banks. Anyon wishing to larn from th markt distortions of th past and rmain profitabl in th long trm whil obsrving th currnt rgulatory rquirmnts will nd simultanous liquidity, funding, collatral, and capital planning in kping with thir businss stratgy and businss modl."

7 contnt Liquidity Managmnt How th intrnal liquidity markt works Th siz of th nt margin in rtail crdit businss is influncd primarily by th rfinancing conditions. Othr factors includ risk prmiums, administrativ xpnss, and capital costs. If a bank wishs to prcisly dtrmin what proportion of its margin it wishs to gnrat via convntional maturity transformation and liquidity rsrvs rspctivly, it first nds to sparat intrst rats from liquidity. This is achivd by rducing th (risk-fr) intrst rat componnt down to a stratgic swap position. This lavs th liquidity componnt, to which intrnal brokrag can thn b applid in ordr to balanc out supply (funding) and dmand (lnding). Howvr, th purpos of liquidity managmnt is not to maintain a balancd pric, but to us targtd incntivs to occasionally ovrrid such a pric. For xampl, liquidity managmnt can offr an additional 10 or 20 basis points to th funding unit in ordr to triggr an incras in rfinancing activitis with maturitis of up to six months. As a rsult, sprad diffrncs btwn liquidity supply and dmand can b comprhnsivly xploitd and substantial arnings contributions can b gnratd. LIQUIDITY MATURITY TRANSFORMATION Intrst (bps) Dmand Supply Funding (Liability) incntivs Lnding (Assts) Tim buckt Volum funds transfr pricing Funding unit Funding cost Risk-fr rat Liquidity sprad Expctd loss Oprating xpnss Capital costs Liquidity managmnt Intrst rat managmnt Nt margin Crdit managmnt Customr rat Lnding unit IF YOU HAVE ANY FURTHER QUESTIONS, WE ARE AT YOUR SERVICE ANYTIME: Dr. Roland Dmml, Partnr [email protected] Waltr Mussil, Partnr [email protected] Dr. Ralf Wincklr, Principal [email protected] think:act CONTENT Editors: Prof. Dr. Burkhard Schwnkr, Dr. Martin C. Wittig Ovrall rsponsibility: Torstn Oltmanns Projct managmnt: Dr. Kathrin Nölling Roland Brgr Stratgy Consultants GmbH Am Sandtorkai 41 D Hamburg [email protected]

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