Sunday, March 19, 2023

Back to the Basics - Lessons from the Current Market Turmoil

 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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