Back to the Basics
With banks collapsing one after another, it is reminiscent
of 2008 when the last major financial crisis hit us. For some, the recent bank
runs might be a shock while others might shrug it off as “history repeats
itself”. But the truth, like with most things, is somewhere in between. So, its
time to look back into the basics to find out what went wrong and what can we
do differently? I have tried to explain it in simple terms below:
Cash is King
In personal finance, people are always reminded to keep
emergency cash (6-12 months) before venturing out into investments. So, why are
financial institutions, and more broadly every company, not mandated to do so? While
there are complex rules for financial institutions to determine how much cash
to set aside (be it Risk Weighted Assets or High-Quality Liquid Assets), maybe it’s
time to rethink “Idle cash is waste of money” adage more broadly and see what
is required realistically? Should we mandate every company comply with
Liquidity ratios (Liquidity Coverage Ratio, Net Stable Funding Ratio) so that
they have enough cash to pay off their liabilities within one year?
Liquidity > Assets
Net Worth = Total Assets – Total Liabilities. Herein lies
the issue as wealth is often defined by assets and liquidity does not feature
in this equation! As this article
eloquently puts it while analyzing why businesses fail, “..lack of capital
will destroy your business over time, lack of liquidity will destroy it in a
heartbeat..”
After 2008, even as focus slowly shifted from Capital to
Liquidity for regulators, companies continued to take on clients with high/
ultra-high net worth without deeply evaluating their liquidity position, often
cutting corners or turning a blind eye when they requested extended payment
timelines or a higher margin call, which are typical liquidity red flags. So,
should the equation that needs to be evaluated during client onboarding really
be Real Worth = Total Liquid Assets – Total Current Liabilities or based on the
Liquidity Coverage Ratio (LCR)?
Banking = Trust
Its not a coincidence that “bank” is a synonym for “trust”.
I will bank on you only if I trust you. And it’s a big IF in the financial
system as the recent events have shown us. Trust, like credibility, is very
fickle. It takes years to build but can very quickly collapse on the back of
one misdemeanor. Funnily, people can lose trust/ credibility based on
perception rather than facts, which makes it very intriguing and not quantifiable.
When people lose trust in a financial institution, it would simply collapse, however
long legacy it may have. Lehman Brothers was around for 161 years and went poof
within one.
Knee Jerk Reactions
Governments, Regulators and Market Participants like banks
are in a symbiotic relationship. Regulators need to broadly align with the
government policies and keep market participants happy. Government and
Regulators are not silly, they monitor the market participants very closely,
and have enough data points to know roughly the strength and issues plaguing
each one. But their main role is to maintain the harmony within their
ecosystem. However, when things go south, governments are pressured by the
common man to take action, who then press the regulators to take action against
errant market participants, so it is natural for there to be some knee jerk
reactions.
Liquidity Component of Counterparty Risk
Lack of liquidity leads to failure of a lot of businesses,
not just financial institutions. Going forward, it would be more prudent for
the regulators to formally embed Liquidity Risk into Counterparty Risk ratings
so that the common man can get factual information about the liquidity risk
profile of a firm, rather than relying on misinformation and media coverage in
order to from a perception of liquidity risk leading to bank runs and failure
of financial institutions.
Technology View
As we move into the next phase of tightening regulations, it
is important for organizations to better understand the holistic picture of
their company as well as those of their clients. As a technologist, I seek to
understand where the challenges are and what can be done to enable the business.
Challenges
Compliance, Risk and Reporting are seen as a cost and a chore
in most organizations. This cost-center mindset needs to change as the impact
of not doing this right is life-or-death for the firm. These functions, in
turn, should position themselves as business enablers, rather than policemen. This
is easier said than done, as large organizations are often complex and no
single person knows everything. This is where technology can help to de-mystify
the landscape, consolidate the metrics, and highlight discrepancies.
The “cost” perception also leads to most firms using
off-the-shelf vendor solutions for these areas to minimize operational costs.
The vendor solutions are typically aligned to regulatory mandates as
interpreted by the vendor. These solutions cater for Financial, Capital or
Liquidity regulations, but do not offer a read-across and are not flexible
enough to cater for every client’s individual needs. While they may offer some
great benefits, they should not be relied upon as a one-stop-shop for all
internal & external stakeholders. Often, the cost of change from one vendor
to another is prohibitive, so organizations that are heavily reliant on
specific vendor solutions tend to get stuck after a while.
Internal application landscape in major financial
institutions is often complex, with legacy applications, disparate systems and convoluted
data flows making it difficult to form a consolidated view across different
metrics. Data duplication and multiple points of adjustments make it difficult
to assess accuracy. Large organizations typically operate in silos with domain
specific SMEs being non-fungible and therefore being unaware/ unable to assess
impact on other functional areas. Businesses grapple with semi-automated
solutions and are overwhelmed with operational priorities. Regulators have been
moving towards element-based reporting (e.g., XBRL standard), but not at a
consistent pace across the globe.
Solution Approach
Loosely connected architecture through APIs or
micro-services would offer the most flexibility and reduced cost of change. This
could be a great way to connect internal applications that produce different
metrics as well as externally to clients, regulators and vendor solutions.
Legacy applications/ services can be re-designed in a cost-effective manner to
offer service endpoints. This approach also abstracts underlying complexity and
allows flexibility of the technology stack being used for each application.
Liquidity solutions should be designed for message/
event-based processing, rather than batch processing, to improve turnaround
times for crisis situations. For example, each cashflow or adjustment should be
separately propagated through the application components/ calculation layers,
rather than re-processing the entire set of cashflows as a batch. Each
liquidity risk event could potentially then trigger a corresponding
counterparty risk re-assessment based on appropriate factors, which could be tuned
through a neural network.
An utopian concept would be to use Blockchain to encapsulate
a single version of every transaction front-to-back, with each function
appending details and calculated metrics as it traverses through the trade
lifecycle. This would avoid data duplication and reconciliations. However, this
approach would probably only be meaningful to new digital banks that start from
scratch as it is not viable to re-engineer legacy applications this way.
Data virtualization tools can be used to provide an
overarching management dashboard with actionable insights from various metrics
to the business. Vendor solutions can be great reporting tools that offer
last-mile connectivity to the regulators (e.g., submission mechanisms, final
adjustments, review/ signoff workflows).
Way Forward
While everyone has an opinion about current events, its
important to learn the lessons from the past and present to apply to the
future. Stay close to your clients and investors, understand their needs, act
on their concerns, be prompt and clear in your communication and most importantly, emphasize the
role of Liquidity in making or breaking companies!
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