Good plumbing will protect liquidity

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More flexible payments for companies risk damaging the plumbing through which money flows and draining market liquidity. Financial institutions and regulators are therefore firmly focused on tightening up liquidity management to ensure that doesn’t happen.

Kevin Brown, Global Head, Transaction Services Products, RBS
Developments in payment systems have given customers greater control and flexibility. For example, through online services, those payments can now be made outside business hours. While this helps customers manage their cash flow, it can put stress on the infrastructures used to move the money around – the ‘plumbing’. These infrastructures, run by companies for ‘members’ which use them for payments, are vital because they keep payments flowing around the world and ensure the underlying liquidity is available. Although they remained robust during the financial crisis, they must adapt to today’s changing market environment, support the enhanced monitoring required and change their funding models to mitigate risk from the system. The solutions to support enhanced recovery and resolution when they come under stress will come through a combination of technology changes and improved business resilience across the banks. Regulators around the world want warning signs of stress to be spotted early to help banks maintain their systems’ integrity and fix any problems quickly. They are also calling for more resilience around intraday liquidity. The Bank for International Settlements (BIS) issued a report on intraday liquidity management outlining reporting requirements local supervisors need to introduce before January 2015. This report included rules on the use of intraday liquidity on nostro accounts – accounts held with other financial institutions to facilitate settlement. This focus requires fundamental change in how banks look at liquidity but will enable them to increase controls, decrease operational risk and manage buffer requirements. Meanwhile, the companies that run the infrastructures are looking at their settlement systems to mitigate inherent risks. They are also working to reduce the reliance on liquidity loss sharing agreements (LLSAs) by all their members if one bank fails. Local supervisors, for their part, want single member default models and a move towards real-time gross settlement where possible. The industry as a whole is contributing to this work. An example is the Bacs payment system in the UK which has introduced hard debit caps as a stepping stone to removing the LLSA and reducing the upper limit on single payments. Direct use of infrastructures is also under scrutiny by supervisors. When it comes to indirect participants – financial institutions which use another bank to facilitate their payments – those with a market share above a set threshold are expected to become direct members of that infrastructure. This will again reduce the risk of failure in the system by spreading use across a greater number of participants rather than concentrating it on a few. An example is the Clearing House Automated Payment System (CHAPS) in the UK, where banks processing two per cent or more of the market volume are expected to become direct participants. To support this, institutions need to be able to monitor and manage their payment and liquidity flows accurately, reinforcing the need to improve monitoring tools. They will also have to provide their own liquidity into the system. The banking industry has historically granted large intraday lines to facilitate the execution of payments during the day. These overdrafts were not considered a liquidity risk and worked with end-of-day forecasting and reporting. However, in future this approach will be inadequate because we have learned that payment flows can change in real time in a stress situation. If, due to such a situation, a large overdraft is not sufficiently funded by the expected level of payments, the account holder will have to look for other ways to fund the position. This might be difficult in a stressed market – hence the call for sufficient liquidity buffers and the requirement to know and manage your intraday liquidity risk. New technology solutions are needed to improve reporting. This is an added challenge as different service providers will collate the information in different ways and to differing standards depending on local supervisors’ rules. It will be insufficient to rely on nostros – which do not report in real time – as this will make it difficult to establish a complete picture. The banks will need to select their service providers carefully to ensure they provide the required reporting solutions. This may also lead to a reduction in the number of nostro accounts used to improve liquidity management. Benefits brought by these changes include improved reporting and greater knowledge of financial positions. But the markets need to guard against over management, which could lead to charging for the use of intraday liquidity or delays in payment processing. These delays could improve an individual institution’s liquidity position but be detrimental to overall market liquidity – inadvertently introducing stress to the market. As more and more payments are now initiated on a real-time basis, it is not sufficient to address these problems with throughput guidelines – which relate to the percentage of payments that need to go through an infrastructure within a certain timeframe. Instead, infrastructures should look for improvements in their systems to function more efficiently when it comes to intraday liquidity. Financial institutions, for their part, need to support their clients with products and services to increase controls and improve liquidity efficiency. This should lead, for example, to a reduction in the number of intraday lines needed whilst still supporting payments being executed in a timely matter. The goal is for all these developments to keep any impact on customers minimal. The infrastructures should facilitate their payments when required without causing concern about the availability of liquidity in the wider economy. They will give financial institutions all they need to spot stress situations early and act immediately to prevent any contagion across the system. In short, the plumbing will hold up.
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