New regulations raise the bar for liquidity management

The thorny challenges of liquidity are about to become a little thornier. If you work in the treasury department of a major bank, the acronyms LCR and NSFR are by now well known to you.

For everyone else, here’s a very brief crash course. As a direct consequence of the liquidity disasters of the financial crisis, capital requirements for banks have been overhauled. The latest Basel Committee measure (Basel III) contains two entirely new liquidity requirements – the Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR).

These are landmark requirements that will apply to all banks. LCR demands that banks can meet their liquidity needs over 30 days, and NSFR seeks to ensure that needs are met over a year.

They will be implemented slowly over a period of three to four years, but the impact is being felt right now, and is severely testing the ability of treasurers to find sufficient and stable liquidity.

The elusive nature of liquidity

The trouble, as treasurers are well aware, is that European policy is pulling the market in two directions. On the one hand, it wants large European institutions to create a liquidity buffer by holding significant quantities of “safe” assets. At the same time, monetary policy – primarily QE - is driving down bond yields, making it all but impossible to secure positive returns on “safe” bonds.

Many core sovereign debt issues now have negative yields and covered bonds have become expensive too. Even peripheral debt and investment grade credit are becoming prohibitively expensive and prices are only likely to get richer as Basel III is rolled out.

In short, treasurers are struggling to find sovereign debt, covered bonds, or investment grade credit at the ideal maturity of one to three years.

The need for diversification

Banks are now searching for a solution to this challenge. A number of larger banks manage their liquidity buffers inhouse through their own traders. They typically adopt an active trading style with high turnover of mainly sovereign debt, while avoiding all credit risk.

However, with negative returns on core sovereign debt and with the difficulty of sourcing suitable assets, many banks are now starting to seek more diversified strategies. They often choose to do this via third-parties to diversify operational risk given how stretched their asset-liability management (ALM) departments already are.

Third-party managers can move investments up the yield curve extending duration and invest in a wider range of assets. If rates rise, investors naturally invest in shorter maturities, making those assets expensive. Ostrum Asset Management’s diversifying approach is to invest in maturities up to 10 years. To offset interest rate risk, the strategy may be executed using swaps. The swaps market is deep and liquid with the advantage of reducing the volatility of the bank net income.

Other assets suitable for the strategy include Residential Mortgage-Backed Securities (RMBS), investment grade credit, and even equities.

One of the big advantages of a fully diversified approach is a reduction of turnover compared with the trading approach, so the overall costs of the strategy should be lower.

Diversification requires skill and resource

In order to generate investment ideas, Ostrum Asset Management’s Interest Rate team draws on expertise from a variety of specialist groups. There is plenty of leeway on duration and few limits on country and credit risks.

The G4 Interest Rate, Credit, Covered Bonds and Inflation Committees, for instance, produce views on market trends while the Euro Sovereign Debt & Agencies Selection Team publishes an opinion on each country, by maturity bucket, in order to select the best securities. The investment management team then ranks and selects the best strategies for the portfolios. Finally, portfolio managers then have a pre-defined leeway for implementing their strategy.

Stockpicking is important but, for very liquid assets, a topdown view is at least as important as stockpicking. At both ends of the spectrum, large and experienced teams of analysts and portfolio managers are required to unearth the best strategies and implement them efficiently.

It’s not just about strategy

While investment expertise is critical, banks also view the risk management of their liquidity buffers through the prism of operational excellence. For many banks, the first questions to a third-party liquidity manager centre on systems, transparency, reporting and operations.

Not only do they want to know that their assets are safe, but they require metrics quantifying the extent to which the instruments used impact their capital, how this may impact the P&L, and how quickly the assets can be sold. They may ask whether the performance of the strategy can be reset every year. They may also impose a large number of constraints on the types of assets employed and how they are traded.

So liquidity managers must be able to customise not only their portfolios, but the reporting of them. After all, in an ever-changing regulatory and market environment, the reliability of the investment process is the minimum requirement.

Published in March 2015

This communication is for information only and is intended for investment service providers or other Professional Clients. The analyses and opinions referenced herein represent the subjective views of the author as referenced unless stated otherwise and are subject to change. There can be no assurance that developments will transpire as may be forecasted in this material.

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