02.The Importance of Liquidity Management- Indian Context

The Importance of Liquidity Management – The Indian Context

KOGNISANCE© Knowledge Sharing Series 3Q 2007 1 of 5

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The Importance of Liquidity Management-

The Indian Context

-Vivek Sharan 1. BACKGROUND

The overhaul of the country’s Payments System by the Reserve Bank of India is bringing about

structural and operational changes which will have a profound effect on the way banks do

business and in particular would effect the treasury departments of the banks and on the way

they manage intra-day liquidity. These changes will create a need for measurement of payment

flows, use of queuing techniques to regulate payment flows, better communications, and a

generally higher awareness by treasury managers of payments processing. Payment operations

will assume some of the characteristics of continuous industrial processes where real-time

measurement is required to assess the buildup of imbalances within the systems, identify gridlocks

within and between systems, and establish more elaborate contingency plans. The

interconnection between systems will also require new control processes in order to cope with

unexpected volume and system changes.

The RBI has implemented a RTGS system, a Securities Settlement System based on the DvP model

to contain systemic risk and a Centralised Funds Management System which would give banks a

centralized view of the balances in their current accounts with the central bank across

geographical locations. RBI also is enabling banks to transfer funds between their various current

accounts located over distributed geographical locations. The Rupee leg of Foreign Exchange

transactions is also to be settled through this system. This would make for efficient and optimised

use of funds by banks but the task of ‘managing’ these funds would become more complex and

only the more nimble banks which adapt quickly to the new environment would be able to

make profits by offering their customers fee based products and reducing its opportunity cost of

idle funds. In this new scenario the management of liquidity would be of paramount importance.

From a systemic point of view the RBI would like to make sure that there is no system gridlock and

would therefore nudge the banks towards better funds management and the banks would find

that payment services will get progressively commodotised and to offer these services to its

clients would require that payment instructions sent on the clients behalf do not get queued due

to a lack of balance with the RBI. A bank could potentially get around this problem by

maintaining balances with the RBI at all times but the ‘cost’ associated with this strategy is





prohibitive. Ideally the bank would like to maintain the minimum balance and just enough funds

to process its outward payments obligations as and when they arise.

2. COMPLEXITY AND IMPACT

The problem of liquidity management is also made more complex because the treasury/funds

management departments in banks would be connecting to different payment infrastructures

(RTGS, NDS-SSS, FX etc) and this will necessitate the management of multiple intra-day liquidity

positions. Banks would be required to put in processes, procedures and Information Technology

systems to establish liquidity and operational bridges between these various infrastructure and

systems. The risk is that the availability of alternative payment arrangements may undermine the

natural balance between inflows within any one system. If left unchecked these imbalances

could grow quickly and lead to system wide gridlock.

Although alerted to the complexity of liquidity management due to the changes in the

payments system many banks are likely to underestimate the challenges. The complexity does

not lie in the implementation of payments system such as the RTGS but in the integration of

disparate systems and working towards integrating the operations and management information

into a unified real-time intra-day liquidity management process. Banks would require the services

of business and information technology consultants with experience of liquidity management

related issues in IT leveraged payments system to work closely with it to provide solutions in

consonance with the banks profile and business objectives.

3. LIQUIDITY ISSUES

The causes of liquidity fragmentation can be broadly classified into the following categories:

operational, technical, policy and bank procedure. It should be noted that the first three

classifications refer to the operations of the payments system while the last refers to the actual

use of the system by participating banks. However, even in this scenario of ‘liquidity pools’ if

banks stick to ‘the rules of the game’ and implement best practices there should be very few

payment problems such as gridlocks, end of day positions and liquidity swaps. The practices of

individual banks and system problems can contribute to intra-day liquidity problems.

The intra-day liquidity monitoring capabilities of many banks would need to be enhanced to

monitor their aggregate and component payment system liquidity positions. Component pieces





include balances in the RTGS account with the RBI, collateral used or available for intra-day

borrowing for processing payments and payment obligations arising from securities settlement

and rupee leg of FX transactions being put through by the Clearing Corporation of India. Banks

unable to appropriately evaluate their liquidity positions cannot recognize nor respond to

liquidity gridlock situations. Banks would need to revamp existing systems and internal

communications procedures to reflect the new need to track positions across multiple systems.

There is a strong need for comprehensive and timely management of real time payments

information. Each bank needs to have a real time, dynamic and unified view of its intra-day

liquidity position so it may develop intra-day payments strategies for such things as timing of

payments versus expected receipts and to use the most appropriate workarounds to fix

problems as and when they arise. This is true for all banks irrespective of size. The larger banks are

perceived to have better systems and procedures but this is not universally true. Indeed some of

the larger banks think that it would be business as usual and they would not be required to make

significant changes in procedures and management information systems.

In an extension of monitoring capabilities banks would need to develop forecasting capabilities.

In today’s business practices banks are familiar with projecting aggregate end of day positions

but will experience difficulties in forecasting positions in a real time environment. Detailed

information required to project end of day positions may not be available due to MIS or

procedural limitations. Banks would need to put in place procedures so that gridlock situations, if

it arises, is addressed by treasury or payments personnel. This would require identification of the

event, addressing the event and who would address/solve the event. Some of the common

problems would relate to exhaustion of collateralized intra-day facilities with the RBI and liquidity

impacts of individual long and short client accounts on the banks overall position.

5. NECESSARY MECHANISMS FOR BANKS

To make the fullest use of the new payments mechanisms and in a sense be the market maker,

banks would need to put in mechanisms to protect their business interests. These could take the

form of developing systematic monitoring capabilities, developing an event matrix for

contingencies’, developing techniques for dynamic queue management and strategise for

proactive treasury management.

• Systematic treasury management: cross system position monitoring processes provide

critical information to the treasury department including opening balances, payments





and receipts processed and payments and receipts pending. These capabilities should

provide real time understanding of current positions and collateral usage and provide

warnings of gridlock situations that are developing or might possibly develop.

• Event matrix for contingencies: the event matrix identifies the array of anticipated events,

corresponding action steps and responsibility for actions. Most (re) actions to gridlock

situations can be addressed in dual fashion first by a banks payments operations unit and

then by its treasury department. Staff training is required to understand the need for such

information and ensure proper actions are initiated once a given situation is identified.

• Dynamic queue management: processes that consider current and projected liquidity of

positions of individual payment systems can eliminate or reduce the impact of individual

bank gridlock situations and the potential for systemic spillover effects. Since payment

operations units would oversee the flow of payments into the payment system they are

the natural first line of defense to address gridlock situations. Payment routing criteria

should include current and projected liquidity considerations.

• Proactive treasury management: when it is not possible to solve gridlock situations

through alternate routing techniques the treasury department can intervene in the

process. For example temporary shortages in the banks current account with the RBI can

be offset by inter-bank loans where willing counter-parties are available.

6. NECESSARY FEATURES OF LIQUIDITY CONTROL PROCESSES

Although future events cannot be fully anticipated it is possible to create a mechanism by

which events can be identified and addressed as they emerge. It is recommended that

banks embed within their liquidity control processes the following concepts:

• Identify market changes: each bank should have a process, formal or otherwise, for

spotting market changes that impact liquidity flows. Once identified such market level

trends can be analysed for its impact on the banks business.

• Identify impact on banks liquidity: impacts on market and individual liquidity positions

can next be projected. Environmental changes in say the securities market must be

analysed for domino effects on the bank in other markets. A complete impact

assessment can then be reviewed by the bank.

• Reconfigure the banks strategic outlook: certain market developments will be of such

significance that banks will reassess their set of component businesses. Decisions to

exit or enter a business and re-deploy capital may well result. The nature of short and

long term liquidity warehousing may also change due to these strategic decisions.





• Establish tactical responses: as strategic responses to changing market conditions are

developed, they must manifest themselves in procedural changes to day-to-day

liquidity management practices and the systems used to execute those practices.

Ultimately all changes to financial flows impact interbank payment systems and

member participants. Those systems and participants will have to alter payment

operations and treasury funding processes as a result of changing strategic direction.

Banks should strive to reduce the number of locations where used cash balances are

available in their current account with RBI (possible through CFMS) to the absolute

minimum given other practical constraints such as securities settlement and

diversification of credit risks.

• Communicate changes and initiate training: once plans and processes are

developed they must be adequately distributed across the organization. Formal

training, process documentation and business continuity plans in support of payment

processing liquidity management platforms are required. Payment operations and

treasury staff must know how to (re)act when situations present themselves. As

changes in the market place are identified all resulting situations that staff can

anticipate should be identified. Corresponding actions and responsibilities should also

be assigned.

• Institutionalize quality assurance: banks should view their intra-day liquidity

management practices in the larger contexts of best treasury management practices

and industry recommendations for payments processing in general. At the most

detailed level banks should also subject their payment practices to quality standards

that relate to both internal and external service level agreements.

7. CONCLUSION

The changes in the payments system would be both a challenge and an opportunity for

banks. The challenges would stem from the shift towards retaining market share, coping

with shorter settlement cycles and falling prices of products and integrating the new ways

of doing business seamlessly into operating practices. The opportunities are present in the

possibilities of offering fee based products and services to customers who are increasingly

demanding innovative payment products.

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02.The Importance of Liquidity Management- Indian Context

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