Cash clearing is often described as the ‘engine room’ of a bank, fuelling its international payments business. Despite its fundamental role, it is often seen as slow-paced and relatively straightforward. Yet, as Christine Thomas explains, a combination of overlapping and rapidly evolving developments mean this is far from the case
A couple of years ago I moved from working on the trading floor into Deutsche Bank’s “engine room” to manage the financial risk of the cash clearing business.
“Won’t that be boring?” and “Doesn’t it just cover plain vanilla cash movements?” were just some of the comments I received when making the switch, accompanied by a raised eyebrow or two.
But after three years I can safely say that’s not true. Changes in risk perception, the regulatory environment and the market environment make cash clearing one of the fastest-moving and most interesting areas of the bank from a financial risk perspective. Each of these themes is a driver of change in itself, but in confluence they can be significant and complex catalysts.
Driver 1: Change in risk perception
Providing intraday liquidity to financial institution clients is part and parcel of Deutsche Bank’s product offering and what keeps the wheels of the global cash machine turning. In this respect, banks must, of course, be prudent when assessing the risk-return implications of extending credit or intraday liquidity at
both an individual counterparty and portfolio level.
The key credit risk in cash clearing is intraday credit lines; where liquidity is released in the morning and is usually squared-off by the end of the day. These intraday credit lines are unadvised and uncommitted in nature. In the past, such exposures would have been seen as a low, or even negligible, credit risk. The Global Financial Crisis put an end to that.
So how do we assess such risks? Indeed, unadvised and uncommitted credit lines do not create Risk Weighted Assets (RWA) and, as such, do not absorb equity. As a result, standard risk-return methodologies such as Return over Risk Weighted Assets (RoRWA) cannot be applied to the intraday portfolios used in the cash clearing space.
We have solved this by developing a clearing-specific methodology that correlates credit quality, risk appetite and revenue on an individual counterparty or client level. By applying this methodology across the entire client universe, individual exposures can be placed in the wider context of the overall intraday portfolio for comparison. This is the basis for active portfolio management along set parameters, such as risk and risk-return appetite by region, industry and rating among others.
Active portfolio management allows us to quickly readjust exposure to changes in the market environment, react to changes in risk profile driven by rating migration, and to be proactive in crisis scenarios. The more comfortable a bank is that its intraday lines are extended to the right names and in the right amounts, the higher the probability that, in times of market stress, these lines – albeit unadvised and uncommitted – will be kept in place, at least to some extent. This potentially makes the whole system more resilient.
Driver 2: Change in regulatory environment
Without intraday liquidity, the international payments business would grind to a standstill. Lehman Brothers is a case in point: news of its default in 2008 caused banks to cut credit lines to financial institution partners, and liquidity dried out.
Since then, regulators around the globe have put increasing focus on the reporting, usage and setting of intraday limits. As part of this, they have started to question banks’ liquidity positions in a stress scenario.
Although the dust is still to settle on the regulatory landscape, it is becoming increasingly clear that there will be a significant focus on the reporting of intraday lines (that is, the maximum intraday liquidity made available to banks), and their usage over a given period of time.
Once usage reporting is commonplace, the treatment of intraday lines as non-RWA might come under threat. Logic says that where there is credit, equity must follow. Yet putting uncommitted intraday on a par with committed credit lines, and asking for equity to be posted against it, will drive up the cost of money transfers – which will ultimately have to be borne by the end users, corporations and private individuals.
Another point of discussion concerns the regulatory request that users of correspondent banking services have intraday liquidity available on a committed basis to ensure that it will not be pulled in times of client or market stress. Again, we are still in the early stages, but this signifies a huge change in mind-set, and one that has already started to trigger the development of a whole host of credit-linked client solutions in the cash clearing sector. One emerging product in this space is ‘Committed Intraday’, which provides some of our key clients with the means to meet their regulatory needs.
Driver 3: Change in market environment
In very simple terms, a bank takes in deposits against interest and provides credit for interest paid. But this new normal environment begs the question: what happens when interest rates are negative?
Clients who leave money overnight in a bank account may face the uncomfortable reality of having to pay for the privilege. The bank has to ‘park’ all cash that it cannot lend out with the central bank and at times when that central bank – for example, the European Central Bank – charges the bank for overnight money,
the cost will be passed on.
One solution is to move money from a normal cash account and invest it in longer-term deposits or capital market products. This circumvents any charges, but it also reduces flexibility and means that the cash isn’t available immediately for, say, intraday payment flows.
Another potential answer could be to combine a cash asset such as a call deposit with an intraday credit line. Instead of paying for long balances on cash account, the client receives interest on the call deposit. During the day, liquidity for payments is provided by the credit line, which is squared at the end of the day.
So while cash clearing may be at the heart of a bank’s offering, the “engine room” metaphor feels somewhat antiquated. Instead, in the modern world, it is rather the processor that drives the banking computer; fast-paced, ever being upgraded and changed, and affected by numerous internal and external forces. It certainly isn’t boring.
Christine Thomas is Head of Financial
Risk, Institutional Cash Management, Deutsche Bank
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