The influence of regulation on liquidity: from problem to solution

June 11, 2020

The Covid-19 crisis has highlighted that financial stress events can occur with little prior warning and may have longer-lasting consequences than past crises. The crash of 2008 saw banks unable to achieve liquidity which led to them contributing to much of the economic stress. Now, regulation such as the countercyclical capital buffer moving to zero has allowed them to pivot, shoring up a much more stable position from which to provide much needed capital relief, and instead, be part of the solution. The response around the world to slow the spread of Covid-19 has significant implications for economic output and will almost certainly cause a severe recession in most economies.

 Some potential implications for the financial sector include:

·        A longer “lockdown” approach which will risk bringing a deeper and longer-lasting recession.

·        A negative impact on bank treasury and asset-liability management (ALM) desks and how balance sheet risk is managed.

·        Banks may have more liquidity and capital than before, but they must be mindful as to how large the debt may be when corporate and retail customers default.

·        As banks deplete capital reserves now, they will need to rebuild them over time resulting in a lengthy road to recovery.

As a result, banks will focus on supporting the customer franchise. The lockdown approach has already impacted certain types of retail and SME customers: the self-employed, those on zero-hour contracts, SMEs dependant on social interaction (leisure, entertainment, etc.) and the export market, more severely than others.

Banks must remain mindful of customer requirements during the crisis whilst considering their ability to repay debt and credit facilities lent to them; credit cards, loans and overdrafts for example. The question here is which customers are in real need, and how will banks steer and prioritise support for them?  

 Adrian Sargent, Founder and Managing Director of ESG Treasury observes:

“Having been at HBoS, specifically as the Treasury lead in Group Strategy, this stress is different in many ways but similar in so many others. It shows stress can come from any sector and places firms, financial institutions and individuals under strain.

Thankfully banks are now better capitalised and have greater liquidity buffers than during the financial crisis, but the risk still exists in terms of the depth, length and severity of the impending recession. Bank of England stress testing shows banks have sufficient reserves of capital and liquidity to cope with the current stress… but we don’t know what the future holds.

Frequent review of balance sheet structure is key whilst balancing customer needs. Indeed, cash and liquidity have been important for banks, as corporate’s stress scenarios and liquidity reserves are being tested now. 

There may be many lessons the corporate world can learn from the formal, and some may say prescriptive, way banks are forced to complete their own stress tests.”

Lessons learned from the past would recommend banks hold extraordinary asset-liability committee (ALCO) meetings as often as required to monitor the balance sheet position, assess emerging stress scenarios and implement management actions as necessary.

The role of the bank’s asset-liability committee (ALCO) is paramount during this time for two key reasons: guiding the customer-facing relationship managers on what support can be made available, and recommending to the Board any temporary adjustments to the risk appetite limits for capital and liquidity risk metrics. “Cash is king” in this environment, not only for balance sheet management but also to enable adequate funding of operational issues (utility bills, salaries, etc). Therefore, the liquidity book should be optimised to cash as far as possible.

Credit risk on any unsecured portion of loans and hence loss provision, erode capital buffers. IFRS9 allows a forward view of credit provision, but in a crisis and at the bottom of the market, the provisions will be higher. This leads to the questions of how many will have capital constraints or when will they hit?

The ability to respond positively and proactively to customer needs is paramount as this current crisis is showing significant implications for all banking customers. Banks are now seeking to support their customer franchise as much as possible which in turn will support the economy and society in coming months.

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