How to improve liquidity accuracy at a time of economic uncertainty

With inflation pressures persisting, central banks across the globe are ratcheting up interest rates and tightening monetary policies,¹“How inflation is flipping the economic script, in seven charts,” McKinsey, July 6, 2022. forcing banks to contend with scarcer and more expensive liquidity through 2023 and probably beyond.²Ryan Cope, Chris Gill, Jayden Liu, and Manthan Pakhawala, “When the tide turns: Optimizing US commercial banking deposits,” McKinsey, April 13, 2022 As the annual reports of many banks show, these forces have already reduced their liquidity coverage ratios (LCRs) and net stable funding ratios (NSFRs) by five to 20 percentage points. Further deterioration will increase costs for funding, and that may have profound implications for operations and profitability.³Miklos Dietz, Attila Kincses, Archana Seshadrinathan, and Dee Yang, “Global Banking Annual Review 2022: Banking on a sustainable path,” McKinsey, December 1, 2022.

Banks can take several proven steps to address the liquidity shortage—for instance, through deposit pricing, active portfolio rotation, and corporate strategy. But these can be expensive or complicated to implement and may hurt the business by diverting resources and forcing changes in daily operations. In addition to such traditional levers, some banks are exploring an alternative way to address balance-sheet expense and funding issues: improving the accuracy of liquidity metrics and the calculation of liquidity positions. Improved liquidity accuracy can identify significant liquidity opportunities and thereby contribute tens of millions of euros a year to a bank’s P&L, at virtually no cost.

One way of improving accuracy is to deploy technical initiatives anchored in key regulatory references, such as laws, technical references, and regulatory Q&As. These accuracy initiatives fall into three categories: regulatory accuracy (by ensuring the correct interpretation and implementation of the regulations for LCR and NSFR calculations), the accuracy of calculations (by ensuring good data quality and calculation processes), and accurate models. Because of the technical nature of these initiatives, they impose no significant costs on the business.

The benefits of improved liquidity accuracy are far from incidental and well worth the effort. Based on Bloomberg data and yield curves, with these liquidity accuracy measures in place, the potential P&L value for a bank with a €1 trillion balance sheet could be above €150 million if high-quality liquid assets (HQLA) and available stable funding (ASF) were released and redeployed in higher-yielding strategies, assuming that ratios were held at the same levels. The typical impact is two to four percentage points for the LCR and one to three percentage points for the NSFR.⁴Assumption of HQLA surplus generated invested in instruments with increased yield of 50 bps, with a direct impact on P&L (assuming a sufficient budget for risk-weighted assets: corresponds to average spread of corporate versus sovereign bonds in maturities from three months to five years for upper-medium investment grade bonds—that is, ratings from A- to A+ (data as of January 4, 2023). Assumption of liabilities released with an expected impact on P&L of 100 bps interest rate costs (typical spread observed between five-year and three-month bonds for the eurozone’s global systemically important banks: average as of January 4, 2023, stood at 143 bps).

Improving liquidity accuracy is a fairly low-cost way to tackle the funding problems, but banks can’t change ratios immediately. McKinsey analysis indicates that results typically appear in banks’ balance sheets after four to six months. Banks usually capture more than 80 percent of the potential after nine to 15 months.

In our experience, banks can apply four guiding principles to improve their liquidity accuracy:

Sprint-based work. The accuracy project should be organized in sprints, typically lasting six to eight weeks. The goal of each sprint is to explore a limited number of initiatives (typically five to ten), prioritized by their potential impact. Typically, the sprints have a two-tiered governance structure for fast validation. One tier involves operational stakeholders (for regulatory interpretation, the calculation engine, and risk, among other things), and the other involves senior stakeholders in finance and risk—up to the CFO and the chief risk officer (CRO). This structure ensures that decisions are made swiftly even on the most complex topics.

A light and expert team. Avoid committing too many bank resources. Mobilize and empower a small project team with the mandate and knowledge to review the liquidity calculation chains end to end, from data sources to regulatory interpretations. Often LCR and NSFR engine experts and regulatory interpretation experts are supported by external experts who can help improve the status quo by providing a fresh, alternative view.

A collaborative approach. To build, analyze, validate, and implement initiatives, the relevant business teams (such as retail, corporate and investment banking, and markets), the metric production teams, and the regulatory teams collaborate closely at the request of the project team. The CFO, the CRO, and other organizational heads commit themselves to collaborate with the project team from day one to ensure internal alignment and the availability of dedicated resources.

A focus on implementation. Early in the process of analyzing initiatives—but before validating them—banks carefully consider the requirements and ramifications of implementation. This initial focus gives banks the time to mobilize the required resources and, potentially, to discard initiatives with low returns on investment.

Improving liquidity accuracy is, admittedly, a bandage in the face of today’s escalating interest rates. But the better you manage liquidity, the less you pay for it—welcome relief in any economic environment. It’s time for CFOs and treasurers to take a more structured and systematic approach to liquidity accuracy.