Following on from the discussion in the previous post on whether bank1 deposits are money the question arises as to what happens when bank depositors try to convert their bank deposits into money – make a withdrawal, write out a cheque, pay a bill or uses any of the other methods to get at the funds. Will the bank be able to meet the demand for cold, hard, cash?
In short, how do banks manage liquidity?
For banks, the problem is actually a fairly simple one to state. Long term, banks typically make money by borrowing short and lending long. As yield curves are typically upward sloping this works well – borrowing borrowing from people who want to deposit short and are prepared to receive between 0 and 4 or 5% to do so and then lending this to people who want to borrow to build homes and pay from 6 to 10%, run credit card balances at around 12% (or more) is a good business. With modern banking practice this even is profitable at a net interest margin of less than 2%.
Given that bank makes the most money by transforming short-dated liabilities into long dated loans the way to make the most money in the long term is to lend it all out and for as long as possible. Great strategy – with only one flaw. Some depositors are inconsiderate enough to want to be able to actually ask the bank to do what the bank has promised to do – pay their deposit at call.
The trick to making the most money, then, is to make sure that you only have enough liquid assets on hand to meet all your depositors calls on the funds and as little as possible more. This is because liquid assets pay little interest, with the most liquid, cash, paying none at all.
Getting this right is the responsibility of the ALM (Asset / Liability Management) function, usually headed by the (gloriously named) ALCO (Asset Liability Committee).
Get it wrong and, no matter how solvent your bank, if it cannot pay depositors calls you will very shortly not be a functioning institution.
Mostly, a quick collapse is precipitated by a name crisis – in brief, your depositors no longer trust you to be able to make good on your promises. They then rush to be at the head of the queue to get “their money” out of the bank. Bank runs out of liquid assets, bank goes phut. In this instance it really does not matter if the bank’s net asset position is strong – if a bank cannot pay it is then in liquidation.
In many countries this risk is reduced through mechanisms like deposit insurance or guaranteed central bank facilities. Both of these have their problems – mostly moral hazard. If you want more on this go here. Suffice to say that, in Australia at least, we have not succumbed to the siren’s song as yet.
Legally speaking, Australian liquidity regulation is governed by APS 210 (Liquidity) and the associated guidance notes, AGN 210.1 Liquidity Management Strategy, AGN 210.2 Scenario Analysis and AGN 210.3 Minimum Liquidity Holdings. As far as regulations go, these are not too bad. They are principles based and flexible enough to cope with most approaches taken by banks. In brief, they mandate the following:
- A bank has to have a liquidity management strategy that is approved by the regulator;
- It has to analyse certain scenarios to show the regulator that they can be dealt with; and
- If a bank cannot satisfy the regulator that they can robustly model their liquidity requirements they have to hold a minimum of 9% of their assets in certain highly liquid forms.
For a small bank this sort of scheme is actually pretty good. Provided the regulator actually has a clue of what they are doing you could do a lot worse. The ALCO can normally take this as a baseline and then build a strategy on this.
Oddly, given that liquidity management is one of the two principle risks facing banks, there are no international accords on liquidity management. It is all left to national regulators – although rumours have it that this may change with Basel III.
Generally, each regulator follows their own path.
For smaller banks (and if you are with a bigger bank do not expect to get a full strategy off a blog – away with you) this needs some real time, thought and, yes, expense.
The first part of any decent liquidity strategy is simple – satisfy the regulations. You may think that this is an obvious point but I have seen this missed. No matter how silly the regulations you will need to satisfy them. If they are bad regulations, seek to change them. If the regulators will not listen, lobby in your parliament. Outright arguing with the regulators will get you into a bad place. Don’t try it. Doctors may say “First, do no harm”. I say “First, satisfy the regulations”.
The second part is to model your requirements. Spend a good amount of time (and money) getting this right. Even if you cannot use a model for regulatory purposes use one. If you start trying to run your bank to minimum regulatory standards it is probably well past time for you to retire. Still young? Cheer up – you may be able to get a job with one of the regulators. Probably only as a junior analyst, though.
Make sure you are able to meet your forecast requirements at least 99.99% of the time. This means that your model will not save you on one day every 2.74 years, worst case.
For those days the third part is crucial. This is having committed back up facilities available on, at worst, 24 hour call. These facilities should be structured to be big enough to get you through a once in a century event. Make sure they are with at least two other, large, banks. Pay the fees. They are worth it and you cannot put them in place when you need them – that is too late.
Lastly – and possibly most crucially, have a good name crisis plan. Review its operation frequently (at least once a year). Make sure the statements from the bank’s Chair are already drafted. Have your media and PR people briefed. Know all the financial journalists in your city well enough that not only do they answer your calls but they call you.
The worst possible way for news of a problem to get out is through rumour, followed by silence (perhaps with a rising background of prayer and panic) and then a rush followed by an announcement from the regulator. Make sure this will not happen to you.
1. As always, I use the term “bank” as a substitute for any deposit taking institution. In Australia, these are authorised deposit-taking institutions, licensed under the Banking Act 1959. In other countries they will be called other things. To the public, though, they are all banks.