Managing bank liquidity in real time

Just a decade ago the concept of bank liquidity was for all intents and purposes only one for the Bank Regulator to really concern himself with. Certainly, a bank had to remain liquid – a critical factor if it were to continue to enjoy the confidence of its depositors – but this criticality was more an “after the event” issue than a live drama that unfolds in real time.

Then banks enjoyed a high degree of anonymity and choice in how it managed its liquidity. This was as a result of the techniques then used for settling interbank obligations. These techniques had been devised and refined over two or more centuries. They had come from a pre-computer world that relied on manual transaction processing of instruments such as cheques. Early moves at computerization of bank processes simply mechanized the manual approach by using the batch processing system. So the critical factor that related to the measuring of a bank’s liquidity could only be determined after the end of the trading day had been completed and all the “ins” and the “outs” were matched up. Even then, a bank had a safety net, provided by the central bank, which in most countries was prepared to cover any shortfall, and then to backdate this cover to the previous trading day.

A growing understanding of settlement risk and the possible contagion to systemic failure led central banks, almost without exception, to implement payment systems, usually under their own direct control that ensured finality of settlement. Real Time Gross Settlement (RTGS) especially where high value payments were involved has become the accepted mechanism of ensuring safety in national payment systems.

This was followed by the need to ensure that the settlement of stock exchange transactions also took place in a secure manner and that delivery of the shares was only against the exchange of a payment that was final and irrevocable. The RTGS approach fitted this need admirably.

Foreign exchange settlements were the next problem. The collapse of the Herrstadt Bank had caused major problems. The solution was provided by a group of major international banks who devised the continuous linked concept of settling one currency against another (a PvP or Payments versus Payments system) in a secure environment, not unlike a domestic RTGS system. Their proposal for the CLS (continuous linked settlement) system won the approval of the major central banks and has been implemented for a number of major currencies. Again the RTGS system was pressed into use to provide the secure payments leg.

Added to this was an additional factor, that of straight through processing (STP), where the ideal is to ensure that transactions right form their initiation in the clients office to their ultimate destination can be achieved no human intervention. The rewards, of error free transactions are immense.

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Of course this shift to real-time transactions and transaction processing and straight through processing (STP) has added to the need to manage liquidity in real time.

Each new payment dimension (i.e. RTGS, DvP, CLS) adds to the complexity of the problem. Funds flows now involve domestic, foreign and securities payments as a minimum – each flow is really dependent on the other flows. There may be other dimensions too, depending on local arrangement and conditions, where other settlements may be require to be settled in real-time and on RTGS principles, such as ACH operations or cheque clearing operations.

The looming complexity of these requirements was the subject of an intensive study in 2000 by the Payments Risk Committee of the Federal Reserve Bank of New York (“Interday Liquidity in the Evolving Payment System: A study of the impact of the Euro, CLS Bank and CHIPS finality”). The study examined the potential implications for US dollar intraday liquidity risks that would come about from planned changes to payment systems in the US and elsewhere. In the words of the committee the report was “intended to stimulate dialogue on the issue and to suggest some possible best practices”. Even though the main focus was on the liquidity effect to banks in the US, the problems and the solutions are applicable to banks everywhere. A key finding of the committee is quoted below in full, as it clearly illustrates the direction in which bank liquidity management has been heading.