The Importance of Liquidity Management – The Indian Context

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
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The Importance of Liquidity Management – The Indian Context

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
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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
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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.
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The Importance of Liquidity Management – The Indian Context

• 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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