Liquidity and risk - striking the right balance

By Arab Bank

In this article, Tony Marcello, Global Head of Treasury Arab Bank Group, explores the impact of the credit crisis on banks, by examining blame, liquidity and redemption, and a return to investor confidence.

One day we shall look back upon this banking crisis and economic stress. We shall have re-learned old lessons and looked all around us for blame, and emerged with a financial services industry which is rather more wary of its shareholders wishes.

The blame game
"To err is human, to forgive, divine."  The 18th century English poet Alexander Pope, in his Essay on Criticism, missed the third part of this cycle of behaviours, which should of course have read "...but to point the finger is understandable too". Blame for the world's current economic predicament has been laid at the feet of a wide variety of people, including politicians, regulators, rating agencies, bank executives, American home buyers, and even David Bowie (reportedly for making securitisation cool in the '90s).

Nonetheless, it is financial services businesses, particularly banks, that have taken a significant proportion of the blame for the prevailing crisis. This blame manifests itself most measurably in share values of banking stocks, which appear to have priced in the penalty for complexity, poor business models, and lack of transparency. It remains true that buyers of bank shares should only have done so after performing a certain level of due diligence (buyer beware, after all). However, with many banks becoming increasingly more complex, adequate levels of buyer due diligence became increasingly more difficult to perform. As a result, buyers trusted banks to do the right thing in remaining appropriately liquid, and to be transparent about the level of risk taking in the organisation. However, as noted by the redefined landscape of financial services today, a good number of banks are seen to have betrayed this trust, and should have known better. The responsibility of banks to remain liquid and within certain risk parameters has been expressed by many, including F. F. Sharles, in his book Business Building (New Era Press).

"(Banks') loans and investments must be "liquid" - capable of quick realisation into actual cash. It is not entitled to speculate with its depositors' money. In fact, if it did so, there would be an end to public confidence in banks."

An erosion of public confidence, caused by banks speculating, is exactly what the market has been experiencing. One should note, however, that this statement is not a recent one, or made with 20-20 hindsight, but was written in 1929. In short, people feel that the banks should have known better, and remained more liquid, more transparent, and more risk-averse. Let us consider this lesson to have been re-learned, and look at what banks can do now to make amends.

Liquidity - How much is the right amount?
Few would disagree that banks, like all businesses, should give shareholders (and potential shareholders), the clearest picture not only of the state of the business, but of the risk profile of the business. This matter of transparency is an issue being aggressively tackled right now by regulators and accounting bodies. As a result, there is broad consensus that disclosure is good, obfuscation is bad, and that there has been not enough of the former, and rather too much of the latter. Let us focus away, therefore, from the call for greater transparency, and look more at liquidity itself.

The topic of liquidity is rather a tricky one, for two principal reasons. Firstly, liquidity (or at least holding it), costs money, and it is therefore in conflict with the bank's need to earn income every year or quarter. The second problem is that no one is yet quite clear on how much is the right amount of liquidity to have.

The cost of liquidity has grown significantly since August 2007, regardless of how one chooses to measure it. At the same time, banks seem to require more of it, having realised that perhaps liquidity hadn't been measured in enough ways. Banks have depended upon the stability of the short-term liquidity markets for a long time. This meant that liquidity performance was often measured only in long-term or strategic terms, such as with the loan-to-deposit ratio (LTD). A bad LTD ratio is clearly an indicator of liquidity risk (as a bank would be funding itself with less repeatable funding than deposits), but conversely, a good LTD simply says that if all cash flows are spaced out nicely, then the business will never be illiquid. Sadly however, natural variation, bad luck, and even crises mean that cash flows can vary greatly on any given day. A bank with a strong LTD can still become illiquid due to short term variations in the availability of (or requirement for) cash, and hence liquidity needs to be measured in different ways. What we have therefore seen is a re-emphasis on measuring daily, operational liquidity, on revising the assumptions which underpin liquidity metrics, and on conservative stress testing of all assumptions and metrics. These new perspectives on liquidity for banks have led in many cases to the realisation that either there wasn't enough liquidity to deal with daily volatility with comfort, or that assets which were thought to be liquid proved in times of crisis not to be. The result has been a vast shift in how banks hold their liquidity. The nature of the shift depends upon the market in which the banks operate, but has mainly involved switching into instruments with a liquid secondary market, a liquid repo market, and, in many cases, sovereign credit risk. This shift has resulted in a greatly increased cost of liquidity, as the yields of these safe havens for liquidity were driven down. Banks, therefore, now spend a great deal more money on preserving liquidity, and this reflects the re-emphasis of liquidity as a key performance indicator.

The second problem with liquidity is that whereas there are guides, recommendations and rules on liquidity from regulators, the Bank for International Settlements, and many others, these are generally qualitative rather than numerically specific. To put it another way, it is clear what good liquidity management practices look like, but it remains unclear how liquid a bank needs to be. Banks tend not to share their liquidity metrics with any degree of detail, and banks' liquidity stress testing models are fiercely guarded secrets. Hence, the setting of liquidity targets can be an imprecise science. Should a bank hold three months, six months or 12 months of liquidity, and what kinds of assumptions should be made behind the calculations?  These are the tough questions which banks are having to ask and answer right now, in the absence of a clear understanding of what stakeholder expectations are.

The answer might be a simple one. Banks need to communicate how liquidity risk is determined in their organisation, and ensure that risk appetite is determined by people other than those who consume it. Banks need to share assumptions and stress scenarios with stakeholders, and convince the world that they are conservative yet realistic when considering and modelling risk. This all falls under the heading of transparency. The result of this transparency will not be evidence that a bank is or is not perfectly liquid, but that the bank concerned cares enough about its liquidity to be judged by its liquidity performance, without concealing the assumptions and detail. This will go a long way towards re-establishing stakeholder confidence.

How to earn forgiveness and what will it look like?
Forgiveness (or a return of confidence), will take a little more than just better disclosure by banks. It will take a redefining and clarification of many banks' business models. The severe fall in bank stock prices reflects the discomfort of shareholders with the risk profiles of banks. Either the risk profiles were discovered to be greater than imagined, or there remains a lack of understanding of what goes on within the balance sheet. Either way, there have been calls for a return to something called "traditional banking values". It would seem that banks have been punished not only for losing money, but for having the wrong business model. When a retail and corporate bank acquires or builds an investment banking and trading franchise, and allows its investment banking arm to dominate, it is only during the good years that shareholders tend to turn a blind eye. For a bank to lose money, (as we have now seen in so many cases) having deviated from its core strengths and business model, is something which cannot be so easily be ignored or forgiven. A return to traditional banking values would be, for example, to encourage retail and corporate banks to do what they do best - borrow and lend in a stable way. After all, most of the world's equity investors value stability over volatility for the majority of their wealth. If equity investors are not gamblers, then they usually prefer the businesses they own not to behave like gamblers either.

Forgiveness by shareholders shall be evidenced by the removal of valuation penalties on bank stocks, and those who will benefit from the removal of the valuation penalty are those banks who become (or remain) focused on what they do best, and on generating the kind of income streams which their shareholders would like to see. Retail and corporate banking, traditionally, has been a stable industry, and income volatility is after all only a relatively recent phenomenon.

Where will the all the risk-taking go?
Bank shareholders will invest in banks whose risk profiles match their own. The desire to take greater risks for greater (albeit more volatile) returns, is one which of course will persist. What will change is which banks are allowed to take such risks. The population of shareholders with the comfort and means to support speculative financial services organisations remains large and cannot stay out of the market for very long. People will still have the desire to outperform, and as soon as it is felt that money is there to be made, then people will be there to make the bet once again. It is this distinct population which may find itself investing less with traditional banks than before, and more with other institutions. .

Large retail and corporate banks will cater towards the majority of shareholders, who have a very limited appetite for volatility or surprises. There shall remain, in the New World Order, a new class of financial institutions, which shall be more highly leveraged, less risk-averse, and small enough to fail. These shall cater to investors with higher risk profiles. As such, they will be centres of leverage, directional trading bets, and non-traditional market and credit exposures. Volatility, and quite possibly returns shall be higher, but the shareholders will have a much more in-depth knowledge of exactly what their business is doing with its capital and liquidity.

It is thus that the banking industry shall redeem itself. In retail and corporate banks, it shall continue to represent the needs of shareholders by servicing the needs of the world's people and businesses for banking services, while generating stable and predictable results. Speculative equity will however be drawn towards hedge funds and smaller investment banks, which will have equally well-communicated business models and risk profiles, but where, with the understanding and support of shareholders, bigger bets and higher leverage are not just tolerated but encouraged.

Contact details:
Arab Bank, Corporate Communication
T: +9626 5600 000 Ext. 5975, E: corporate.communication@arabbank.com.jo