Strategies for Liquidity Management in Banking Finance Essay

The global financial crisis in the second quarter of 2008 brought down not only the United States but also the whole world, estimated to destroy more than $1,4 trillion (IMF 2008b). The causes are known as the vicious cycle related to low interest rates, securitization, and bubble of housing market. All of them laid the world into turbulence, which is aggravated by the huge number of specialized mortgage lenders and securities unregulated by the government institutions. The necessary of reviewing the progress of financial innovation wakes the bank specialists up out of the illusion of stable development. This crisis is called "the crisis of liquidity" when the market became more and more illiquidity. Many compact of bailouts are funded to rescue economics in some powerful countries like the United States, the United Kingdom, and Germany; however, there are still some countries which just suffered the small influence, the most noticeable one is Australia. Many questions are prompted like "Why could Australia pass through financial crisis so quickly and albeit continue developing?" or "What is the strategy of liquidity management that Australian banks, especially Australia and New Zealand Group (ANZ bank), one of four major banks in Australia and among just 11 AA-rated bank left in the world, used to pass over the crisis?". To answer the above questions, we need to review and analyze the foundation of banking system in Australia as well as the liquidity management activities in Reserve Bank of Australia and one representative bank in Australia, Australia and New Zealand Group (ANZ Bank). This assignment will be divided into 2 main parts to discuss Australia in financial crisis and what ANZ Bank did to sustain the shock of financial market. In the first part, I will concentrate on how Australian economy survives through the crisis successfully. In the second one, the strategy of liquidity management of ANZ Bank will be analyzed to find out why they could maintain the sustainable liquidity management strategy, how they could preserve capital and attain effective liquidity and well managed structure. To begin with, some definitions about liquidity and liquidity management need to be clarified. We could realize that the liquidity risk is one of the most difficult risks in financial intermediary, especially banks. Generally, liquidity management can be understood as one of the most significant activities of bank management which ensure banks have sufficient liquidity to meet obligations as they fall due "without incurring unacceptable losses".

Reserve Bank of Fiji (1995, p3) defined that banks could maintain sufficient liquid assets to meet obligations or any unprecedented situations by having appropriate liquidity management policy. Additionally, Gallinger G.W. and Healey P.B. (1987, p.3) stated "Liquidity management is the allocation of liquid resources overtime to meet resource needs for payment of obligations due and for various investments that management undertakes to maximize shareholder wealth. This activity related to the requirement of availability of resources at time and the control of various financial risks". We could realize clearly the importance of liquidity management through above definitions. In reality, when a bank could not maintain the liquidity effectively and the assets become illiquid, it could go bankrupt if the central bank does not rescue it out of the stress condition. Therefore, sustainable liquidity management is considered as essential "future proofing", insuring the end-to-end process is maintained. In the below illustration, we could understand explicitly the level of sustainable liquidity management, it stands on the top of pyramid, proving that if managers control successfully reserve management, risk management, portfolio performance, they will target to sustainable liquidity strategy. Regarding banking sector, the core activity of a bank is highlighted as the business of collecting and taking deposits that are liquid and convertible on demand and transforming them into medium or long term loan for corporations or individuals who have the demand. Matthews K. and Thompson J. (2005, p. 91) argued that there are two main risks that a bank faces on its balance sheet, which are default risk and withdrawal risk beside many other risks such as price risk, payment mechanism risk, foreign risk and the risk of settlement. The former is caused by the circumstance in which the borrower will be default whist the latter is relatively related to liquidity risk. The main function of asset and liquidity management in banks is the allocation of liabilities of the bank to earning assets to reduce the risk of default as well as the maintenance of sufficient liquid assets to minimize withdrawal risk. In reality, a bank could be situated into the circumstance in which lenders effort to convert their bank deposit into money to by making a withdrawal, writing a cheque or even use anything they could do to have the fund as they want while the bank tend to make the largest money from short term deposits to long term borrowers to maximize the bank's benefit. In this situation, the bank should make the most money in the shortest period and meet all depositors' demand as little as possible due to the zero interest return to bank when they keep cash as liquid assets. This risk could be reduced by having deposit insurance or guaranteed central bank facilities. On the other hand, the bank also has to face with the default risk of borrowers, especially in the crisis like the previous period, the bank managers need to diversify their loans into different sections of the economy such as geographical region, type of industry. In order to assure partly the probability of borrower default, banks also need to obtain collaterals from their borrowers. Furthermore, liquidity management involves managing reverses to meet predictable outflows of deposits. They could hold the rate of sufficient reserve, borrow from inter bank market or at the discount window from the central bank. A simple model of liquidity management includes the bank balancing between the opportunity cost of holding reserves rather than earning assets and the adjustment cost of having to conduct unexpected borrowing to meet withdrawals. The bank need the compatible allocation its assets between high risk, high - return loans and low risk, low return assets as well as a risk free asset and risky asset. There are four ratios that are supposed as the measurement of liquidity ratio, which are: Loan to Deposit Ratio: Bank use to calculate at the end of each month, it implies how a bank is funding illiquid assets by stable liabilities.

Ratio = (Total Loans, Advances, Leases and Bills/Total Deposits) x 100%

Loan to Adjusted Deposit Ratio: Bank compute at month end, an adjusted loan to deposit ratio. It illustrates the deficiencies in the loan to deposit ratio by finding how medium and long term debt fund for the bank.

Ratio= (Total Loans, Advances, Leases and Bills/L1) x 100%

With L1= Total Deposits + Borrowings + [Reserves - (Investment in Subsidiaries + Investment in Fixed Assets)] + Issues of Medium and Long Term Debt + Debentures (3) Liquid assets to Total Deposits Ratio

Ratio= (Liquid Assets/Total Deposits) x 100%

(4) Liquid Assets to Total Assets Ratio

Ratio= (Liquid Assets/Total Assets) x 100%

Australia overcomes the global financial crisis

Despite the global financial crisis impacted on the world economy strongly, Australia has been one of countries which show early positive signs of recovery. One of the main reasons that help Australian financial market survive through the crisis is that Australian banks are highly capitalized. Banks in Australia operated under the Basel II Framework from 1st January 2008, ensured 8%, which is a prudential capital ratio (PCR) of total risk-weighted assets. In this 8%, a half is the compulsory percentage regulated by Tire 1 capital (the highest-quality capital components). In reality, Australian banks usually go beyond the lowest capital requirements despite they are not required to increase new capital to balance loan write-downs. In November 2008, at the peek of the international credit crisis, Australian Prudential Regulation Authority (APRA) summarized that Authorized Deposit-taking Institution (ADI) maintained the requirements of capital adequacy, so they were well-capitalized. It is proved by the return on equity was 17% which accounted for five largest bank in Australia at the end of 2008. Moreover, Australian banks have two different sources for funding: approximately 50% from the deposits of customer and wholesale funding, the remaining percentage from short term and long term in both the domestic and global markets, which proved that Australian bank have the strong funding resources. The other reason is that sub- prime mortgages in Australia in mid 2007 just accounted for the small percentage, approximately 1%. Securitization does not take the main role in lending activities in Australia and intermediations still dominate the financial market, while the percentage of securitization in the United States is around 13%. Mortgages and Collateralized Debt Obligations (CDOs) just took the small size in the whole Australian sub-prime market, which makes the balance sheet of Australian financial institution become very stable. Noticeably, Standard & Poor rated more than 66% CDOs in Australia AAA, marking the considerable increase from 58% in 2005. The CDOs in Australia increased dramatically over 6 years from 2001 to 2007, especially synthetic CDOs, which develop rapidly in the growth of CDOs. According to Global Financial Stability Report (2008), the provisioning of Australian banks continuously marked the highest number guaranteed the most stable economic before the financial crisis in 2008, even it continue keep that point during the chaos of finance market. Another point that should be highlighted is the importance of issuing bank debt and asset backed securities (mainly Residential Mortgage Backed Securities -RMBS), especially from 2004 to 2006 so that the liquidity of banks in Australia increase remarkably, help the volatility of banks become stronger. The previous turbulence of financial market waked the regulators to review the current regulations in national level in order to certify that liquidity management of banks is effective in turmoil, when people struggle for cash, for their fund immediately and do not believe to the stability of banks.

Australian Regulations of Liquidity Management

The government in Australia, particularly Australian Prudential Regulation Authority (APRA), has issued Australian Prudential Standard (APS 210 Liquidity) and three confederate guidance notes: (1) AGN 210.1 Liquidity Management Strategy, (2) AGN 210.2 Scenario Analysis, (3) AGN 210.3 Minimum Liquidity Holdings based on "Basel Committee" "Sound Practices for Managing Liquidity in Banking Organisations". They are composed with some fundamental and flexible principles for banks to easily modify and adapt it into their own operation strategies. The below graph illustrated clearly the requirements which are defined in AGN 210.1: (1) Liquidity policy statement: It means that Australian banks and other deposit-taking institutions have to follow the first stage in liquidity management strategy, which is composition of details in their own strategy, approved by the Board of Directors or Committees. (2) Measuring, Assessing, Reporting Liquidity System: Besides some compulsory information such as the market values of liquid holdings or the maturity of cash flows, they will imply to the potential cash flows related to its assets and liabilities. (3) Procedures for managing liquidity: Banks could determine various liquidity management procedures based on its own capacity and standing in the market. It could be: Maturity Mismatch Limits Liquid Holdings Diversification of Liabilities Access to Wholesale Markets Foreign Currency and other Markets Intra-group Liquidity Use of Assets Industry Liquidity Support Arragements Responsibilities and Controls (4) Responsibilities and Controls: it points that bank managers need to defined clearly management responsibility and control structure, report its liquidity status in timely and effective manner. (5) Contingency Planning: It will clarify who would take responsibility of identifying the unexpected problem, the necessary information for planning the solutions, the cost of funding strategy and the consequences of the ADI's capital, if possible. Banks are required to update and ensure the effectiveness of contingency plan, which remind staffs frequently about their roles in the plan.

Liquidity Management Strategy at ANZ Bank

Australia and New Zealand Banking Group (ANZ Bank) is one of four major banks in Australia which recovered soon after the financial crisis. It marked the significant development and is well-known as a strong capitalized and sufficient liquidity bank. They have maintained the solid result against the downturn of global financial crisis and have impressed everyone by robust foundation, strict liquidity management. They target to the perfect regional liquidity risk controlling solution, making clients believe to their services and use it whatever countries they go, and clients could consider ANZ as their beloved home. It is now regarded as the pioneer bank in Asia markets in expanding the market shares and the reputation with the efficient strategy based on the huge capital as well as their concentration on risk management and balance sheet management to enhance liquidity for their operation. Due to the fact that ANZ have the strong capital position and profit, they could improve capital ability whenever they want. In the turbulence caused by financial crisis, ANZ bank still keep its credit rating in the high position and ensure it have maintained credit rating. ANZ has resisted to financial crisis more effectively than many other banks, so it does not need bailout for its own considerable resilience. The strategy in liquidity management in previous financial crisis facilitated to the strong of ANZ against the crisis, named "Culture of prudent lending". It could be demonstrated that ANZ is capitalized with a well diversified and stable funding foundation and an impressive record of energetic profitability. In August 2009, they acquired with selected businesses of the Royal Bank of Scotland (RBS) in East Asia for about $ 500 million, marked the larger expansion in Asia, following the strategy "Becoming a super regional bank - a bank of global quality with regional focus".

After the financial crisis, ANZ becomes not only the prime position in Australia but also one of the best banks in Asian market. ANZ is highlighted by the liquidity management strategy and procedures, which makes the Group has enough liquidity to fulfill the obligations. The foundation of liquidity management strategy is constructed by the following principles: The Group target to maintain the conventional, low risk approach to liquidity management. ANZ holds high quality liquid assets to support day to day operations. ANZ reports the scenario analyses in which ANZ have to prepare for the "going concern" and "name crisis" The Group ensure to meet "survival horizons" under the different scenarios from the normal business to the stressed condition, at the site and the whole Group level, to fulfill obligations in medium term Establishing specific contingency plans to cover various liquidity crisis events. The Group aims to use various funding foundations, avoiding undue concentrations by investor type, maturity, currency or source. ANZ ensures the liquidity management framework is relevant to the documents of government. Managing the structure of balance sheet to ensure resilience in the liquidity and funding risk profile. Limiting the potential earnings at risk implications related to the unexpected increases in funding costs or the liquidation of assets under stress. We could illustrate clearly the framework of liquidity management of ANZ Bank as the following graph: Comparing the above principles with the requirements of APRA, we found that ANZ obeyed fully and have prepared thoroughly for the liquidity risk, ensuring they could survive in the turbulence and develop to another level of development. Among eight components in the above framework, I think the most noticeable features in ANZ's liquidity management strategy are the Scenario Modelling, Liquidity Portfolio Management and Liquidity Risk Contingency Planning. Due to the constraint of time, I will concentrate to discuss on three important ones. The first compulsory component is "Scenario Modelling".

Regarding the daily liquidity risk management, ANZ analyses their liquidity position under two different conditions: (1) cash flows in adverse operation to the bank, it has difficulty in fulfill obligations to depositors; (2) cash flows will be the same in now or future. It helps ANZ could use the information of liquidity to predict the behavior of customer and prepare the scheme. Researching the strategy of ANZ Bank in liquidity management strategy, I could point that scenario modeling is the most outstanding component in the framework of in liquidity management strategy. They adhere to the requirements of reporting the behavior of cash flows in normal business and difficult condition. The former means that ANZ assesses liquidity under general business activities plans the scheme to meet all commitments and obligations in normal funding capacity, over at least 30 calendar days, Assessing the maturing wholesale funding against rigorous capital market disruption; in which no wholesale funding can be issued or tumbled, explains explicitly why ANZ could have sufficient ability to meet its going concern commitments. As protection against this future funding obligation, ANZ controls wholesale borrowing requirements against both its liquidity portfolio and limitation for domestic and offshore wholesale debt maturities. In contrast, the latter mentions to the model in potential "name crisis", it may have some difficulties in rolling over the funding and have to guarantee that the cash flow is positive over five working days. ANZ model this scenario based on customer type, level of sophistication and the type of asset/liability. Furthermore, the Group also prepares the scheme to against any unexpected circumstance in a range of other stress tests and liquidity scenarios over the period of time. To check the group's solvency, the outcome is the period of tight liquidity has been experienced over the last 12-18 months, which has raised the funding costs. They model and manage the probability and earnings impact of changes in the group's credit margin to assess these risks. This uncertainty may be happened due to the market factors or the downgrade of credit rating. Noticeably, the global financial crisis has exposed the difference between stressed and normal market conditions in a name-specific crisis, and the different behavior that offshore and domestic wholesale funding markets can happen during market stress events. Therefore, ANZ has maintained its liquidity risk scenario modeling to support APRA's requirements.

ANZ has linked its liquidity risk appetite to defined liquidity "survival horizons" (how long ANZ must maintain a positive cash flow position under specific scenario or stress), in which customer and wholesale balance sheet asset/liability flows are stressed. The following stressed scenarios are modeled: * Extreme Short Term Crisis Scenario (ESTC): a name-specific stress during a period of market stress * Short Term Crisis Scenario (NSTC): a name-specific stress during a period of normal markets conditions * Global Funding Market Disruption (GFMD): Stressed global wholesale funding markets leading to a closure of domestic and offshore markets. * Offshore Funding Market Disruption (OFMD): Stressed global wholesale funding markets leading to a closure of offshore markets only. They have managed those above modeling in regional operations as well as the whole Group's level. Another point that I want to mention is the liquidity management strategy is improved by the holding "a diversified portfolio of cash and unencumbered high quality". Those highly-liquid securities will be traded to guarantee intraday liquidity by supplying cash immediately, especially in stressed conditions. Those assets are suitable for repurchase agreements with the applicable central bank (repo eligible). According to Goodhart C.A.E (2008), if banks can maintain liquidity successfully in a sustainable price, they will not worry about the maturity transformation. In nine months in 2008, the holding of eligible securities expanded from $14.6 million to 34.7 billion, responded to the volatility and turbulence of financial crisis at that time. This achievement is supported by the number of Australian internal mortgage securitization (RMBS), accounted for $ 10.3 billion. Meanwhile, the volume of eligible securities held, post any repurchase discounts applied by the central bank, was $60.2 billion. ANZ targets to improve its balance sheet by maintaining the strong coverage ratios of liquidity portfolio to maturing wholesale offshore debt maturities. The table below analyzes liquidity portfolio holdings held in ANZ's major funding centres:

Eligible securities (Market Values)

2010 ($m)

2009 ($m)

2008 ($m)

2007 ($m)

Australia 20,974 18,694 12,899 9,281 New Zealand 7,547 8,771 6,620 5,474 United States 1,275 1,301 2,739 3,070 United Kingdom 2,183 2,939 4,157 2,251 Asia 4,204 1,984

Internal RMBS (Australia) 26,657 24,508 8,305

Internal RMBS (New Zealand) 3,812 1,954

Total 66,652 60,151 34,720 20,076 Source: ANZ Annual Report 2008, 2009 and 2010. In the above table, we could see clearly the dramatic increase of securities holding at ANZ Bank in four years from 2007 to 2010. The total volume in 2007 just accounted to $ 20,076 million and in 2010, it reached to $ 60,151 million in which internal RMBS took the main role in this growth. Particularly, RMBS in Australia raised remarkably about $ 18,000 million, from $ 8,305 million to $26, 657 million. Meanwhile, eligible securities in Australia doubled the volume, from about $9 million to over $ 20 million in 2 years. It could be said that ANZ Bank has managed successfully the portfolio serving for the purpose of maintaining liquidity status. In order to strengthen its balance sheet, ANZ Bank continues to keep the strong coverage ratios of Liquidity Portfolio to maturing wholesale offshore debt maturities. It is diversified by counterparty, currency and other factors. The portfolio is diversified by separate counterparties, is summarized in the below table: Long term counterparty credit rating Market Value ($m) 2010 2009 AAA 51,371 43,827 AA+ 8,094 3,043 AA 6,169 10,849 AA- 694 1,867 A+ 120 264 A 204 301 Total 66,652 60,151 Source: ANZ Annual Report 2009, p. 147 and ANZ Annual Report 2010, p. 161. In the above table, we could see clearly AAA counterparty accounted for the large percentage, approximately 77,07% in 2010 and 72,86% in 2009 while the lowest credit rating A counterparty just took 0.3% in 2010 and 0.5% in the previous year. It proves that ANZ Bank really concentrated on the quality of counterparties, which strengthens the long - term development of this bank, instead of choosing the low credit rating ones. The last one I want to emphasize here is "Contingency crisis planning" in which ANZ adhere to the requirement of Australian Prudential Regulation Authority about the preparation against liquidity risk at country level or global level.

The framework includes: The foundation of crisis stress levels Explicitly authorized roles and responsibilities if crisis happens Plan responsibilities for communications Early warning the probability of crisis and how to deal with it Crisis Declaration Assessment processes against the above warning Sketch out the action plan for adjustment asset and liability Procedure for reporting crisis management, and making up cash flow shortfalls The primary customers in case of crisis happens Regarding intraday liquidity management, Bech M.L. (2008) pointed that intraday liquidity management is really necessary for the banking system to ensure the liquidity in daily transaction. Banks could use the collateralized credit as the "pledging collateral" to the central bank or having an intraday repurchase agreement with the central bank. Similarly, in Australia, Reserve Bank Information and Transfer System (RITS) plays the role as Australia's high-value payments system where ANZ Bank and other banks settle their payment obligations on a real time gross settlement (RTGS) basis. After that, payments of ANZ are transferred into RITS directly or delivered by SWIFT and Austraclear. RTGS was opted by Australia in over 10 years ago, 1998, with the purpose to decrease the probability of settlement risk, which could affect to the liquidity management of banks in Australia. Regarding the department that is responsible to liquidity management, the Risk Committee is one of three main Committees of ANZ's Board, which assists Board of Directors in dealing with liquidity, operational, credit management and others related ones. Two senior management committees are responsible to management of market risk, in which the Group Asset and Liability Committee (GALCO), is executed by Chief Financial Officer, mainly deal with non - traded market risk, including liquidity risk. Source: https://www.anz.com/about-us/corporate-responsibility/our-approach/risk-management/structure/ In ANZ's strategy, they find out the minimum risk assets and liquid assets, then attempt to measure asset liquidity and funding needs for asset growth, inflows and outflows; otherwise, they also assess the collaterals in order to calculate probability to funding. They maintain the effective liquidity management strategy in which they could recognize the warning signals like illiquidity spirals, market wide stress and the interaction between liquidity risk and market risk, credit risk, operational risk. However, the world changes days by days, so bank could not apply the same strategy for the different periods in operation. Therefore, ANZ's treasury department plays a role as controlling center for any changes in strategy to improve the ability in decrease liquidity risk. Continuously, I will focus on the fact that profile of bank's liquidity management changes overtime with the improvement of techniques and combinations between information and technology, so data and information management becomes more and more important in the future development of banks, especially in the exposure of financial crisis. It could be said that aggregate and adequacy data could strengthen the capacity of bank. The more information they have, the more successful they would be in the unprecedented situations. We know that designing the effective liquidity management strategy requires a lot of time and capital, but we could not deny the benefit they create for a bank, especially the stability for a bank. Achieving the successful liquidity management strategy will situate ANZ Bank into the new level of development in which they could maintain efficiently balance consolidation, total balance, net balance application and the state equilibrium of balance. All of them will strengthen ANZ Bank's liquidity risk management and financial flexibility.

Until now, ANZ have a well equipped infrastructure consists of high qualified human resource and modern technical system, which facilitates ANZ Bank the prosperous management of the risk generally, cash flow data specifically and could suppose the potential cash flow in future model with the consistent degree of certainty. The bank managers concentrated on operating transparency, resilience of technology, which could facilitates fund following planned ways. They collected the report, analyzed the data and target to balance the liquidity risk. They pointed to internal movement, combination and the integration with other factors. Notably, in order to increase the ability in controlling liquidity risk, ANZ Bank decided to corporate with three other banks which are Barlays, J.P. Morgan Chase and Mizuho Corporate Bank in joining Cable and Wireless Real Time Nostro Service, allowing them manage cash flows efficiently. ANZ Bank expected that this brilliant standard infrastructure adopted across different systems, currencies and time zones will work as a fundamental home of data, so they could know more about the cash movement globally through agents, including those for exchange, commercial payments and securities settlements. Therefore, they could minimize the risks related to foreign currency, securities settlements with international regulations, and enhance the operational efficiency. Moreover, banks could manage cash flows in all currencies and time zones intraday despite of the markets have closed or even many days later. Aggregation of account data will allow banks to identify risk such as unprecedented overdrafts or potential defaults within the settlement day. In conclusion, this paper has summarized and analyzed the strategy of liquidity management of Australia in general and ANZ Bank in particular. It can be said that the well-prepared preparation in policy of liquidity management issued by Australia government, particularly Australian Prudential Regulation Authority, strengthen the capacity of Australian banks in liquidity management and rescue them out of the global financial crisis faster than other countries. I could be summarize that the sufficient liquidity of ANZ Bank is supported by many important factors like modelling of scenarios, liquidity portfolio management, liquidity crisis contingency planning. Those components have created the best strategy in liquidity for ANZ Bank and continue improving to the higher level of long term development in future. A new era has begun; banks need to develop the fully integrated risk management framework, instead of the current market and liquidity risk assessment which are still inadequacy. The better liquidity management banks maintain now, the further stable development they achieve in future.

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