New regulatory liquidity standards will force significant changes in how banks manage their balance sheets, impacting both the treasury group and the business lines.
With the finalization of new regulatory rules on the liquidity coverage ratio (LCR), large banks for the first time will be required to operate within defined liquidity standards, in addition to meeting tougher regulatory capital requirements. This will force significant changes in how banks manage their balance sheets, impacting both the treasury group and the business lines. Leading banks are preparing now to meet these challenges.
There is a temptation to relax now that treasury groups have calculated the LCR position for their respective banks and established corporate strategies to ensure compliance. For many banks, there are still significant build requirements for information systems (e.g., to support daily reporting), but treasurers are calm, believing they can meet further LCR requirements within the mandated timeline.
It is an eerie tranquility, for two reasons. First, the banking industry is more liquid now than at any time in the last 50 years — a result of de-leveraging during the crisis and tepid post-crisis loan growth. Second, the Fed’s Quantitative Easing (QE) has flooded the banking system with approximately $4 trillion in deposits.
Will LCR Affect Smaller Banks?
LCR rules apply to banks with more than $50 billion in assets. Smaller banks, while immune from LCR rules for now, suspect increased liquidity regulation may be coming their way soon. This is likely to start through the supervisory process, with examiners applying LCR calculations to these banks and continuing with formal liquidity rules for banks above $10 billion in assets. Many of these banks are already informally calculating their LCR positions and taking actions to improve their liquidity profile in situations where initial test results varied significantly from official compliance levels.
In any case, LCR rules will affect the broader deposits market, forcing small banks to play in a different landscape:
Increased competition for highly-valued retail deposits. LCR rules provide favorable treatment for retail deposits, especially insured retail deposits. Industry insiders expect increased competition for these deposits; through more aggressive pricing; product, service and distribution enhancements; or both.
Decreased competition for non-operating commercial deposits. LCR rules provide less favorable treatment for commercial deposits, especially those commercial deposits classified as non-operating. To the extent that these cannot be reclassified, industry insiders expect structural changes in the competition for commercial deposits to structurally change.
Innovation in LCR-friendly products. New deposit products with features that improve LCR treatment are being brought to market. This is already evident with 31-day notice deposit accounts.
Increased usage of Federal Home Loan Bank funding. Borrowing capacity at the FHLBanks has no LCR value, while long-term advances are very beneficial to LCR. This will make advance rates an important reference rate for small banks.
— Peter Gilchrist and Steve Turner
These forgiving circumstances for bank liquidity will begin to reverse with QE ended, loan growth picking up and accelerating economic activity. In a not-so-distant scenario, meeting LCR requirements could become far more difficult than what bankers are experiencing today.
The upshot is that many banks risk being caught under-prepared to cope with the strategic balance sheet implications of LCR. With commercial and retail deposits, for example, LCR fundamentally changes the value of various products and accounts — with major implications for Treasury and the business lines. Banks are just starting to address these differences.
Savvier banks are already making strategic choices about how deposit businesses will need to evolve to maintain profitability in the new landscape. They are adjusting the design and pricing of deposit products to ensure offerings meet customer needs while providing the requisite profitability and liquidity for the bank. But before changes are even considered, most banks have work to do in building foundational data and advanced performance metrics to evaluate their strategic choices.
Major Changes; Major Questions
LCR rules are specific on the calculation of liquidity sources and uses, which affects the valuation of balance sheet items and, in turn, the commercial and retail business lines. On the asset side, acceptable sources of liquidity have been narrowed and their contribution tiered: government-backed securities approach dollar-for-dollar regulatory liquidity value, but other types of investment securities receive large haircuts and are of more limited use.
On the liability side, certain types of deposits receive high liquidity value under LCR rules while others have no value at all, significantly affecting their absolute and relative worth. For example, insured retail deposits in transaction accounts are the bulwarks of LCR liquidity strength, with almost all of these balances available for funding loans. By contrast, non-operational commercial deposits and corporate/interbank deposits will receive a much lower liquidity value, limiting the amount of these deposits available for funding loans.
The situation has created a series of important questions for the commercial banking operation; the retail banking operation; and the treasury group.
The commercial business is asking:
- How can we reformulate treasury services to meet customer needs profitably, given that the liquidity contribution of treasury services deposits has been cut by at least 25%?
- What is the role for non-operational commercial deposits, given their much lower ability to fund loans under LCR? What changes should be made in their structure and price?
The retail business is asking:
- What is the ceiling on the value of insured retail deposits? How should we be positioned for a potential bidding war that LCR could touch off for these deposits?
- What role should uninsured certificates of deposits play? Should a term CD with severe early withdrawal penalties be part of the bank’s deposit funding strategy?
Treasury is asking:
- What information will be needed to optimize funding?
- Should pricing decisions be based on marginal or average liquidity impact?
- How should the costs of a liquidity buffer be reflected in funds transfer pricing?
These questions must be addressed to make sound strategic choices. The commercial business will want to refine the treasury services product offering (and associated pricing) so that it continues to be profitable. The retail business will want to consider the lengths to which it will seek to retain highly valued deposits, even at the expense of rates, fee waivers or other profitability compromises. Meanwhile Treasury will need to consider multiple LCR-informed funding scenarios, depending on business line decisions and unfolding market influences.
For each strategic choice, executives must evaluate a variety of unique-to-bank factors such as retail strength; commitment to commercial treasury services; the outlook for loan origination; and access to capital markets. Intuition and back-of-the-envelope analytics will be insufficient in a world with so many moving parts. At a minimum, LCR-related decisions will require strengthened foundational data and performance metrics.
Foundational data. To formulate the best treatment for deposits, the business lines and treasury group will require new levels of detail on customers, account types and account usage. The lines of business then need to understand how differences along these dimensions will affect the value of deposits.
This speaks to the need for an integrated deposit analytic ecosystem. For the first time there are hard dollar differences in the value of different deposits, giving treasury, commercial and retail a keen interest in “single source of truth” data. Banks that make this foundational information consistent and available to all constituencies will be better prepared to attract and protect the highest-value customer deposits.
Performance metrics. Most banks already are incorporating regulatory liquidity calculations into FTP, but there still are many questions to be sorted out. For example, there are a range of practices for valuing liquidity; translating liquidity costs into FTP; and determining how to charge for the liquidity buffer. Also there are differences in bank situations that lead to different liquidity valuations. All of these points must be considered when designing FTP methodologies.
Some banks look to apply an LCR tweak to FTP and call it a day. This will fail to meet the mark, as envisioned tweaks rarely allow FTP to reflect the full dynamics of liquidity cost and value. For example, most time-worn performance metrics value insured and uninsured deposits the same; ignore regulatory factors in decay rate assumptions; and derive volatility estimations (betas) from pre-crisis events that occurred in a more stable climate.
Additionally, many banks are still relying on performance metrics that are unequipped to determine how liquidity values will change when the institution or the industry shifts from excess liquidity to liquidity needy. There is clearly a lot to do. This work needs to be agreed upon and implemented in advance of making strategic decisions on product design and pricing.
LCR rules are changing balance sheet management. These new rules, combined with an increased appreciation of liquidity value since the crisis, are causing banks to revalue deposits and adjust deposit strategies, product design, and pricing. Deposits with the highest regulatory value will be heavily fought over. Products must be redesigned with terms friendly to LCR treatment. Pricing will incorporate the cost and value of liquidity.
All this leaves banks with a succinct list of tasks:
- Fix foundational deposit data. As discussed elsewhere in this issue (“Integrating the Deposit Analytic Ecosystem”), banks need to build a “single source of truth” for deposit data so that analyses for the treasury group and business lines are built on the same underlying information.
- Refine FTP to incorporate LCR treatments. Through its outflow assumptions, LCR introduces a regulatory viewpoint that establishes universal deposit decay rates. FTP should incorporate both the universal LCR decay rates and internal analytically-based decay rates.
- Adjust product design and pricing. Once the right metrics are built on a solid data foundation, the business lines and the treasury group can make the critical decisions on adjusting product design and pricing.
- Enhance treasury funding strategies. The effects of LCR on bank funding instruments will make it more difficult to identify optimal funding strategies. Treasury will need to monitor balance sheet dynamics and create scenario-specific funding strategies.
Some banks expect plentiful liquidity to persist, supporting ongoing balance sheet flexibility and limiting the need for detailed LCR planning. But they are at risk of being caught flat-footed. Tomorrow’s winners are preparing now for a changed liquidity environment.
Peter Gilchrist and Steve Turner are Managing Directors at Novantas Inc., a management consultancy based in New York City. They can be reached at firstname.lastname@example.org and email@example.com, respectively.