Real-time monitoring and control of bank liquidity

Real-time monitoring and control of bank liquidity

Until around a decade ago, the bank regulator's exclusive focus was on ensuring that banks had sufficient liquidity. In order to maintain depositor trust, a bank's liquidity was essential, but this was more of an "after the event" concern than anything that happened in real time.

Then, banks had a great deal of freedom and secrecy when it came to managing their liquidity. Because of the methods employed to settle interbank commitments at the time, this resulted. Some of these methods have been around for at least two or three centuries. As a result, they had grown up in a pre-computer world that depended on the manual processing of financial instruments such as checks. The batch processing system was used to automate the manual approach to bank activities in the early days of computerization. A bank's liquidity could thus only be accurately assessed after the trading day's close, when all of the "ins" and "outs" had been tallied. As far back as then, the central bank in most nations was willing to cover any deficit and then backdate this cover to the prior trading day.

In order to mitigate settlement risk and the potential for systemic collapse, practically all central banks implemented payment systems that were under their own direct control and guaranteed finality. Secure national payment systems are increasingly dependent on real-time gross settlement (RTGS), particularly when large sums are being transferred.

Furthermore, it was essential that all stock market transactions be settled in a safe and irreversible manner to guarantee that the distribution of shares was based on the exchange of a final and irrevocable payment. The RTGS technique was a perfect match for this situation.

The next issue was dealing with the settlement of foreign currencies. The Herrstadt bank's demise had caused a great deal of distress. PvP, or Payments against Payments (PvP), was created by a consortium of big multinational banks, who came up with the continuous connected notion of settling one currency against another (like a domestic RTGS system). CLS (continuous linked settlement) was approved by the main central banks and has been implemented in a number of major currencies, including the U.S. dollar. The safe payment leg was once again provided by the RTGS system.

Additionally, the concept of straight through processing (STP), which aims to guarantee that transactions are completed without any human involvement, was a consideration in the decision-making process. Error-free transactions provide enormous benefits.

Real-time transactions, transaction processing, and straight-through processing (STP) have increased the demand for real-time liquidity management, as one would expect from such a change.

There is an additional layer of complexity with each new payment method (RTGS, DvP, and CLS) introduced. When it comes to the movement of funds today, local, international, and security payments are all necessary components. Other dimensions, such as ACH operations or check clearing activities, may need real-time and RTGS settlement as well, depending on local arrangements and requirements.

For this reason, a thorough investigation was conducted in 2000 by the Federal Reserve Bank's Payment Risk Committee (see "Interday Liquidity in the Evolving Payment System: A Study of the Effect of Euro-Related Issues, CLS Bank and CHIPS finality" for more information on their findings). The research looked at the possible effects of proposed changes to payment systems in the United States and worldwide on US dollar intraday liquidity issues. In the words of the committee, the study was "designed to generate discourse on the topic and to recommend some potential best practices." Despite the fact that the major emphasis was on the liquidity implications for US banks, the issues and solutions discussed here are universally relevant. The following is a complete quotation from one of the committee's primary findings, which depicts the current state of bank liquidity management.

It is essential that treasury managers become more aware of changes in payments processing operations as a result of these changes. Real-time measurement will be necessary to analyze the accumulation of imbalances inside systems, detect gridlocks within and across systems, and construct more sophisticated contingency plans in payment operations, as in continuous industrial processes. In order to deal with the unanticipated volume and system changes, the linkages between systems will need new control mechanisms.

The management of a bank's liquidity is a crucial part of its operations. The impact of real-time money transfers on bank operations has yet to be completely appreciated by many financial institutions, however. For the most part, they've just been concerned about the impact of the local RTGS system up to this point.

A bank's primary challenge will be different depending on its size. To provide an example, at a smaller bank, the challenge may be to "about" balance the amount of incoming and departing cash flows. Because of the massive amounts of payments sent and received practically constantly throughout the day, the bigger banks are immune to this kind of issue. A natural flow of cash aids in the matching process, making it easier for them. There is additional depth to this real-time component in nations where CLS is fully active. As a consequence of their interactions (which is real-time Forex settlement), the RTGS system and the CLS system have created a wide variety of new situations. Another example of this is the RTGS's interface with the securities system.

Consider the situation as if it were a game of chess. Real-time liquidity management is comparable to a two-dimensional game of chess in terms of the challenges offered by RTGS systems on their own. A chessboard is only complete when it includes the inclusion of CLS, securities, and other real-time money flows. It's possible to imagine these additional boards as stacking up like chessboards in three dimensions, one above the other. Each game has an impact on and interacts with the others since they are all being played at the same time. Any level of checkmate may lead to a level of checkmate on all the other levels as well. The classic chess game is replaced with a three-dimensional version.

Managing intraday payment liquidity effectively requires extensive technical and analytical know-how. Until recently, it was impossible to overcome the technological challenges of properly adopting such a system throughout a bank. This is being transformed by new technology.

Payment inflows and outflows are effectively modeled on a timed basis throughout the trading day using this system's fundamental idea. Three important sources of data are needed to represent these flows:

Making use of the most recent data availablePayouts that have previously been received or made are "In the Pipeline" statistics. The information about "pending" transactions RTGS queue payments, CLS payments, and any other commitments may all be included in this. Certain inbound payments, such as CLS settlements, may be predicted with accuracy.

Payment flow forecastsIn some cases, unaccountedpayment flows for the rest of the trading day may need to be estimated. Based on historical data, this information may be adjusted for the day of the week, month of the year, and so on.

An RTGS system's timing of these multiple flows may be completely random, or it may be tied to pre-determined settlement timings, such as for ACH, securities, and CLS. Payments that need to be covered are basically the whole spectrum of payments that the bank deals with. A typical bank may include any or all of the following:

RTGS (real-time gross settlement)

Direct or sponsored participation in the CLS, or normal foreign exchange flow responsibilities

Settlements of securities

The "credit" flow of money is all that is involved in all three flows, which implies that payments are produced when the payee bank is paid.

The regular debit and credit payment flows, as well as the Giro type payments

Clearing processes for checks and credit/debit cards, including EFTPOS transactions,

In addition, the central bank or other parties may settle real banknote withdrawals and deposits.

Credit and debit transactions are often processed in the same system in these four instances, making them more complicated. ACH transactions that include both credit and debit payments would be an illustration of what is being discussed—a bank sending out credit payments, while debit payments would reflect an influx of cash. Due to the fact that many transactions are returned for one reason or another, the procedure is made more complicated. Cheques will not be paid; credit transfers cannot be applied since the account has been closed; etc.

The usefulness of these latter four systems is sometimes cited as a reason not to include them in a bank's overall liquidity management system, despite the fact that they represent a large number of transactions. This all depends on the banking norms and practices in the nation where the transaction is taking place. The value of cheques and non-RTGS electronic payments in certain countries may be more than the total amount of RTGS transactions. Cheques, for example, are still a substantial volume and occasionally have a considerable value in certain other countries.

Managing intraday payment flows is a simple concept in theory, but in practice it may be rather challenging.

In order to manage their total liquidity situation in terms of assets and liabilities, many of the world's biggest banks utilize the strategies mentioned below, which are based on that procedure. Over the course of many weeks or months, banks use this or a variant of it. A bank's intraday and end-of-day payments flow may be managed using this method.

For bigger banks, this strategy is focused on their use of the framework because of the wide and varied payment systems they use. However, this approach is equally relevant to the measurement and management of banks' payment liquidity, even for small domestic banks. Centralized liquidity management, good management, information systems, and analysis of net financing needs under various scenarios are the cornerstones of this approach.

Preparation for the worst-case scenario

All of these things are necessary for a bank of any size or scope to have effective payment liquidity management.

A smaller, more local bank or a bank that participates in fewer payment systems is likely to be able to apply the technique more easily than a larger, more international bank.

The "Treasury Manager" of a bank is comparable to the general in a war zone. All of his assets are made up of liquid assets: cash on hand, credit lines available to him, and international bank accounts. He has to wage a fresh "war" each and every day to guarantee that his institution has the liquidity it needs to continue its daily operations. He must not only have the necessary funds on hand, but he must also have a variety of tactics at his disposal in order to wage this "war." Derivatives, swaps, repurchase agreements, and other financial instruments will be among the tools he employs.

A crucial component of the Treasurer's day-to-day activities will be the information he needs for his new "war" with liquidity. Current day transactions and flows will be included in this information.

Some extremely intelligent computer that combines all of these sources of information into a single scenario that the bank treasures can effectively use for transactions that have not yet reached the "pipe-line," but are based on known occurrences, trends, and previous data.