Regulatory capital is no guarantee for survival

What is Basel II / Basel III / Basel Quattro?

The Basel capital adequacy framework and directives originating from the sleepy chalet of Basel describes a more comprehensive measure and minimum standard for capital adequacy that national supervisory authorities are now working to implement through domestic rule-making and adoption procedures.

It seeks to improve on the existing rules by aligning regulatory capital requirements more closely to the underlying risks that banks face.

In addition, the Basel II Framework is intended to promote a more forward-looking approach to capital supervision, one that encourages banks to identify the risks they may face, today and in the future, and to develop or improve their ability to manage those risks. As a result, it is intended to be more flexible and better able to evolve with advances in markets and risk management practices.^[1]

All this is supposed to give us a warm and fuzzy feeling about the state of banking regulation world-wide, or insofar as it impacts our little corners. It is supposed to give the average investor and depositor the confidence to rest assured that the financial institution is immune from risk, particularly systemic risk as it has adequate capital coverage; but is that real, practical, and relevant?

Did Basel Capital Adequacy Directives help?

Eight days before it was nationalised, Northern Rock had a total capital adequacy ratio of 14.4%, nearly double the 8% required by the Financial Services Authority, in line with Basel II guidelines.

Halifax Bank of Scotland (HBOS) as of 31 December 2007 had a total capital ratio of 7.7%, based on Basel I guidelines, and the notes commented on the fact that during 2007, the FSA approved the group’s Advanced Measurement Approach (‘AMA’) operational risk and Advanced Internal Ratings Based (‘AIRB’) credit risk waivers and, as from 1 January 2008, the bank would be operating under the Basel II capital ratio regime.

This advanced capital regime supposedly will redefine both the size and nature of the capital resources available to HBOS as well as the level of risk weighted assets.^[2]

So why then, did these two organisations not show any immunity to the worsening crisis seen in 2007/2008, and expected to continue well into 2009? 

Based on Basel II governance statements and the banks’ own admissions, their capitalisation structures would stand them in good stead, but it did not prevent either of these organisations to navigate through the sub-prime fuelled financial meltdown. 

The last months have been akin to the famous Queen classic, ‘Another one bites the dust’, as one hallowed institution after another caved into pressures which could not be averted through capital management or indeed capital regulation.

Capital adequacy directives, and indeed anything that has been outlined by central banks as positive governance, has not been subject to either robust stress tests, and neither have these been tried out in crises situations.
It has now become painfully clear that the regulatory regime worked well in good times, but at the first sign of a crisis, it could not withstand the financial pressure. This is no criticism of the capital adequacy framework but an admission that this framework could not withstand a global cauldron as has been seen in the recent past.

If not capital adequacy, then what?

These pressures that caused the demise of most financial institutions that I alluded to did not relate to capital, and in the case of most banks that went under in the UK, did not relate to sub-prime related lending.

It resulted on account of liquidity mismanagement which wiped out their positive cashflow structures within a 2-3 month period resulting in debilitating cash operations.

Liquidity, up until 2007, was rarely mentioned in regulatory circles, and which was accorded step-motherly treatment by almost all regulatory regimes, was the ‘forgotten risk’, an ‘Asian’ problem, a ‘Russian’ problem, or not an issue since it is guaranteed by the Central Banks.

It is now apparent that the central banks of this world do not believe in the concept of lender of last resort as Northern Rock was allowed to crash and burn, without any overt endeavour on the part of the regulator or the government in power. 

Capital adequacy ratios cannot and will not assist you in a liquidity crisis simply because the amount of capital held has no relevance to an organisation’s cash position and strengths. Capital is an accounting book entry and is no substitute for short-term positive cash flows. It is therefore time for the regulatory regime to take a hard, long look at its cashflow policies, and embark on a ‘physician, heal thyself’ journey.

What is the alternative?

Financial institutions must undertake a more searching examination of their balance sheet structures, and decompose their balance sheet into contractual, and more importantly, behavioural cashflow buckets.

Most retail lending and funding organisations have to contend with customer behaviour as a key rationale for the understanding of mortgages and non-determinant maturity cashflows, and without a good understanding of customer behaviour analytics, any structure of liquidity will not be complete.

Every financial organisation must have a functioning liquidity contingency plan, and more importantly, trigger points when such a plan should be instantaneously activated. 

The plan should not just be a policy document but an operational guide that should identify alternative sources of funding, the mobilisation of personnel and resources within the organisation, the wherewithal to handle press and media, and the communication channels with key investors, depositors and stakeholders.

A set of liquidity scenarios must be drawn up for testing on a daily basis, and the results should be analysed over the coming 60-90 days. Liquidity crises are never long-term, and the scenarios drawn up must establish clear action guidelines that invoke the liquidity contingency plan and ensure that the plan does not become outdated.
At least once every six months, the financial institution must provide the results of simulation tests conducted, training provided and other activities undertaken to strengthen its ability to carry out the contingency plan successfully. 

The bank should provide to its Asset Liability Committee (ALCO) a general assessment of the bank’s overall preparedness to address a possible serious funding problem, and this should be part of every ALCO meeting.

Back to basics

It is not possible to use standard liquidity ratios for liquidity management for the following reasons:

• The adequacy of a bank's liquidity will vary.
• In the same bank, at different times, similar liquidity positions may be adequate or inadequate depending on anticipated or unexpected funding needs.
• Likewise, a liquidity position adequate for one bank may be inadequate for another.

Determining a bank's liquidity adequacy requires an analysis of the current liquidity position, present and anticipated asset quality, present and future earnings capacity, historical funding requirements, anticipated future funding needs, and options for reducing funding needs or obtaining additional funds.

Developing Liquidity Scenarios

The impact of shrinking liquidity can clearly be seen from the attached graphic, which highlights the fact that all risks have a direct and tangible bearing on liquidity. If an organisation manages liquidity, it essentially is managing its survival.

Liquidity is governed by both internal and external factors, and these should be analysed for any liquidity issues that may arise in the next 30-60 days.

These indicators are not a complete list, but are generally useful in assessing the bank’s overall cashflow and liquidity profile, key cash inflows and outflows, and the impact of these on the bank’s cash management policies.
Some of the key indicators that need to be reviewed for liquidity are:

• Widening funding spreads
• Increased usage of limits
• Temporary funding difficulties, or rejected borrowing requests
• Increased dependency on best funding sources
• Difficulty finding new funding sources at the same or similar rates
• Decline of stock prices relative to peers
• Downgrades
• Steady and tangible decline in earnings
• Increase in level of non-performing assets
• Significant asset growth or acquisitions
• Pressure to buy back liabilities or support market
• Successive quarterly losses
• Continual growth of problem loans and loan losses
• Successive ratings downgrades
• Significant change in customer behaviour

Each of these indicators should then be quantified with a set of reports relating to:
• Cash flows or Maturity Ladder
• Customer deposits and customer behaviour
• Anticipated draw-downs
• Limit utilisation
• Low cost funding
• Alternative sources of funding
• Off-balance sheet commitments

Each of these reports provide a clear understanding of the organisation’s funding and lending needs, and produces a comprehensive framework for modelling cashflow routines for liquidity management needs. Without these, an organisation would surely suffer a liquidity crisis sooner rather than later.

A set of standard scenarios should be developed and run daily and the results can then be assessed as follows:
This will ensure that on any given day, the organisation is looking at its liquidity position; its maximum cumulative cash outflows are analysed based on not just contractual obligations but also customer behaviour characteristics, and the organisation assesses its non-determinant maturity deposits on a consistent basis. Liquidity results can thereafter be stress tested as follows:

Note that the stress tests take into consideration new business and rollover forecasting assumptions and therefore provide a more meaningful review of cashflow dynamics.

Liquidity goals, as a minimum, must encourage the following:

• Increase customer funds
• Decrease dependence on
– Interbank
– Intergroup
– Large Funds Suppliers
– Cross Currency Funding
– O/N Funding

Liquidity reporting as a minimum must include the following:

• Analysis of funding requirements
• Limit application and excess reports
• Satisfy regulatory requirements (BIS, OCC, others)
• Concentration Risk analysis - volume, mix (investor, product, industry)
• Liquidity Ratios
• Contingency Funding Plans

Attention must be paid to alternative sources of funding, particularly to avoid the re-occurrence of a Northern Rock-like concentration risk. 

According to their own financial statements, As at 30 June 2007 around 75% of Northern Rock’s total funding was sourced from the non-retail money markets with £53.8 billion of their total non-retail funding balances of £80.5 billion, i.e. two thirds, raised from securitisations and covered bonds. 

This risk can be diversified away with a more active foray into the customer-behaviour driven retail deposits world.

Key Next Steps

Regardless of the method or combination of methods chosen to manage a bank's liquidity position, it is of key importance that management formulates a policy and develops a monitoring system to ensure that liquidity needs are met on an ongoing basis. 

A good policy should generally provide for forward planning which takes into account the unique characteristics of the bank, management goals regarding asset and liability mix, desired earnings, and margins necessary to achieve desired earnings.

Forward planning should also take into account anticipated funding needs and the means available to meet those needs. The policy should establish responsibility for liquidity and funds management decisions and provide a mechanism for necessary coordination between the different departments of the bank.

This responsibility may be assigned to a committee. Whether the responsibility for liquidity and funds management rests with a committee or an individual, strategies should be based on sound, well-deliberated projections.
The board of directors and the examiner should be satisfied that the assumptions used in the projections are valid and the strategies employed are consistent with projections.

The future of financial institutions is fraught and in these troubled times, the onus on survival cannot be left to the regulatory watchdog, but instead, organisations should be blood-hound like in actively managing key risk areas, of which liquidity is the most prominent.

The days of patting oneself in the back on account of higher than required capital adequacy are not just numbered, they are a thing of the past, and the only way forward is self-regulation.

[1] https://www.bis.org/publ/bcbsca.htm
[2] Audited financial statements as on 31 December 2007