By Armel R. Kouassi, Head of Balance Sheet Modeling, Northern Trust
What, for you, are the benefits of attending a conference like the Liquidity Risk Management Congress and what have attendees learnt from your session?
My session was about assessing the viability of the balance sheet as firms face growing pressure to be regulatory compliant and provide flexibility to the business. This question is, what I am trying to achieve on the day to day basis? How bank optimize their balance sheet within multiple constraints, achieving profitability is at the center of banks strategy. If there was a single topic to learn from at the conference given the multidimensional pressure facing banks it is certainly the session on balance sheet management. Attendees learnt from my session how your bank can develop an effective balance sheet optimization program that supports the company strategy while maintaining the stability of the balance sheet, and improved profitability.
How can risk professionals maintain balance sheet stability and risk appetite?
A stable balance sheet is a balance sheet strong enough to weather a storm wherever this storm is coming from. Managing the balance sheet stability within the risk appetite is one of the most important jobs of a banker. Managing Banks balance sheet can be a complex and technical subject, but it deals with some of the most significant strategic and operational questions that banks face. A clearly articulated asset-liability management framework with appropriate limits framework ensures that risk exposure are measured, reported, proactively managed and maintained within the board risk appetite.
The financial crisis was a tipping point that triggered significant changes within the industry. Regulatory and industry changes have accelerated, banks needed to ensure their asset liability and risk management practices maximize opportunities, drive growth, and fuel the next big ideas while staying within the bank risk appetite. Indeed, capital, liquidity, funding, and leverage ratios, as well as recovery and resolution planning, were forcing banks to construct balance sheets and businesses that comply with all constraints while aiming to fully utilize the capacity under the ratios. This limits banks’ strategic degrees of freedom and demands a new, highly analytical business-optimization and strategy-setting process. The regulatory, technology and competitive landscape are shaping up banks strategies.
Without giving too much away, in your opinion, is the balance sheet too stable and restricting business/undermining shareholders?
There is no single answer to this question. In general banks have enhanced their capital and liquidity base, deleveraged leading to a stronger balance sheet. Regulatory pressures, transformation of the competitive landscape and increased complexity have put pressure on banks’ ability to deploy effectively their balance sheet to be profitable. The issue today is that the multiple regulatory burden, emerging risks and new competitors can put pressure on the banking industry to effectively deploy effectively their balance sheet. It is less about the stability of the balance sheet but more about the ability to utilize their balance sheet to the maximum capacity within their risk appetite to generate shareholders value. Executing strategic balance sheet management is a difficult challenge for many banks, given the multiple regulatory constraints.
How can firm’s best prepare for unforeseen circumstances and future crisis?
We are in an era where banks have to transition to mindsets of risk control to risk insights and risk intelligence, anticipate, be nimble and forward thinking. The traditional backward-looking approach to risk, which evaluates potential risks on a siloed basis is no longer adequate; the new normal is an integrated enterprise-level risk management framework which link risk appetite tangibly to business strategies. Considered balance sheet management as an integrated value chain rather than a collection of siloed processes to tackle the next crisis and new challenges arisen.
The pace of transformation of the industry is phenomenal. Bill Gates stated all the way back in 1994 that “Banking is necessary, banks are not”.. Bank’s need to keep their strategic goals, risk profile, managerial constraints and exogenous influences into account as well. To best prepare for unforeseen circumstances, banks need to undergo a process of rapid holistic transformation, in particular banks need to equip themselves with few key capabilities:
- Develop an enterprise wide risk management culture. Establish robust Enterprise wide risk management framework that provide risk intelligence and identify emerging risk holistically.
- Identify and assess both the impact of and potential mitigants to potential resiliency threats
- Manage and anticipate emerging risks. Digital transformation will be a crucial help. Bankers and risk managers should quicken the pace at which they embrace and deploy new technologies.
- Strengthen the balance sheet, forecasting ability, digitization, analytics, innovation and agility. Ability to decipher within the data which is made readily accessible in structured manner.
- Hold enough capital and liquidity buffer to absorb unexpected losses
- Focus on the increased threat of cyber-attacks and enhancing or replacing legacy IT systems.
- Accelerate technology advance: Evolving economic circumstances and changing custom behavior have created an environment ripe for disruption of the typical business model bank.
- Enhance the banks ability to proactively manage its balance sheet and forecast the balance sheet under different macro-economic environment.
- Align incentive across business units through robust funds transfer pricing process.
- Design and maintain contingency plans to address any issues arising
How do you see the liquidity risk landscape changing in the next 6-12 months?
The largest banks in the world have significantly improved their liquidity position since the great financial crisis. Liquidity risk management requirements will continue to have a significant impact on the profitability of global financial institutions that do not manage them carefully.
1) Now that liquidity risk management has become the norm, the significant change I see in the short term is the transition of banks from regulatory tactical focus on liquidity risk management to a longer term strategic solution:
- Better integration of liquidity forecasting into strategy and business planning.
- Optimization of liquidity buffer to utilize the bank capacity efficiently and avoid excessive liquidity buffer – this required linkage of liquidity risk measurement other risks such as credit and market risk which drive liquidity flows under stress.
- Integration of liquidity into funds transfer pricing frameworks to ensure that liquidity costs and benefits are correctly allocated to Business units’ profitability to incentivize the risk behavior.
2) Another change expected is the transition to alternative reference rates. The transition will impact many parts of the banking operation. Liquidity risk management will be impacted: liquidity risk could be increased due to different fall back rates that are only short term solutions. There could be challenges in refinancing as available alternative are mostly overnight and not sufficiently liquid. Challenges are also expected in intercompany loans and agreements. Banks should start planning the transition immediately.