AsianInvestor: how Asian banks manage liquidity

Asian Investor, April 2013

Asian commercial banks face a range of challenges in their liquidity management and treasury needs. Regulation limits their options; capital buffer requirements leave less surplus to invest; and yields on highly-rated assets are so low as to be problematic.

Yet Asian treasury and liquidity managers do have it easier than their peers elsewhere in the world. “Despite constraints on asset quality and earnings, we believe adequate capitalization, strong liquidity, and government support will underpin our ratings on most Asia Pacific banks,” says Ritesh Maheshwari, primary credit analyst at Standard & Poor’s, which has a stable outlook on 78% of the Asia Pacific banks it covers. “Stable core deposits constitute a large portion of Asia Pacific banks’ liabilities, and these banks generally have good liquidity positions.”

So Asian banks are not cash-strapped, but nor do they have a huge amount to deploy, nor many credible options if they do. So how, in this difficult environment, do Asian commercial banks handle their liquidity? DBS, as the most regionally diverse homegrown bank in Asia, represents an interesting case study.

DBS has dedicated functions for liquidity management in the front and middle office, with teams of full-time staff handling liquidity and funding in Hong Kong, China, Taiwan, Indonesia, India, the UK and US, in addition to Singapore. “Our key business activities are in those six countries in Asia,” explains Andy So, Managing Director, Treasury & Liquidity Management at DBS, to whom these teams report. “The UK and US are key international markets for funding, so we need a team in those markets.”

Liquidity management at DBS stems from the bank’s key role: lending money to corporate and retail clients. “For the bank it has been and will continue to be our approach that we fund our loan growth by growing the deposits,” says So. This is also the norm for most healthy commercial banks in Asia.

The need for liquidity management arises when deposits exceed loans, which in any well-run bank they do; indeed, there is usually a regulatory requirement for this to be the case. In China, for example, the loans to deposits ratio has a regulatory ceiling of 75%. Some of this difference will need to be kept in order to meet liquidity requirements, but beyond that, there is a surplus to be managed.

“We have been in situations where we have more deposits than loans,” So confirms. “Where there are surpluses after meeting the liquidity requirement, they can be deployed to support other key businesses.” In DBS’s case, the main business that takes this support is its treasury and markets team, “which has a function to trade different types of financial products, from cash to derivatives and to provide solutions to our clients. That particular business activity also has a funding requirement.”

Funding the treasury and markets division is one of three ways that DBS manages its surpluses. The others are to set aside funding for medium to long-term investment; and the deployment of balances to preserve liquidity. “The objectives of these three different activities are distinct,” says So.

Each has its own framework and parameters and involves a different approach. “For treasury activities, it’s up to a trader’s view on market opportunities,” says So. “They can capture a very short dated market window to create a gain.” For investment activities, DBS normally looks for at least a one-year horizon, “though the contractual maturity could be much longer. Then they will look at the outlook of the market where they see value and opportunities, and put on the investment.” With the remainder, “for me to manage any residual surpluses to preserve liquidity, I would just deploy into some very liquid assets with short term tenor.” All the various teams work and invest in local currencies, and also in US dollars.

The split between the three approaches is confidential, but So says it depends partly on recent history and partly on the tradable opportunities bankers foresee. “We have an internal process to discuss and agree the funding allocation to each of these business activities each year.” He can’t be specific on a typical split, but does say: “On a relative basis, the funding needs for our treasury and market activities are definitely much smaller than our funding needs for loan growth. And in our investment portfolio, again it will be smaller for treasury and markets funding.”

The bad news for external fund managers is that with a fairly simple range of assets to invest in, there’s little need to appoint anybody outside the bank to do it. DBS manages liquidity and trading 100% in-house. “We could, if we wanted to, appoint external managers to manage a portion of our investment funds,” says So. “But in practice, we manage it ourselves.”

And this appears to be a illustrative of the broader market. One fund manager Asian Investor spoke to used to run a business in Singapore offering a high grade credit fund with modest leverage, and enjoyed plenty of investment from local bank treasury units. “It was a way for smaller banks to put proprietary money to work in a diversified way,” he says. “You could give them 150 names under a single note allowing them very good capital treatment.” But the financial crisis put paid to that: the business did survive, but appetite for doing anything risky with surplus funds had gone.

A manager at another house in Singapore says there is talk at his firm about developing a business to cater for commercial bank liquidity management needs, “creating a facility for them to use our expertise to manage their liquidity,” but it has not yet made sense to press on with it. “The issue is, it’s a 10 basis point business. Perhaps with sufficient scale, bringing in sovereign wealth and central bank money as well, you could generate a successful business, using a money market fund capability that would hopefully be attractive to regional banks. But I’m not convinced it’s going to generate enough business and fees for it to get too much focus.”

Why? What changed in the financial crisis, given that most Asian banks survived it in good shape? Partly it’s regulation, partly bank prudence. “Following the 2008 global financial crisis, bank regulators and management became much more conservative in how they allowed treasury liquidity to be managed,” says Brian Baker, CEO of Pimco in Asia. “While not pervasive, there were some banks in Asia that had exposure to subprime ABS and SIVs issued by various banks.” Nobody appears to be doing that anymore, and in most countries could not even if they wanted to. “Asia is a very diverse region so different countries have different regulator regimes,” Baker says. “Some countries do not allow commercial banks to outsource management of the treasury liquidity book. Others do, but in those countries that do allow this – Thailand, Hong Kong, Singapore – it is not a common practice.”

So at DBS notes that recent developments in regulation have mainly affected liquidity management rather than trading or investment. “We have to observe all the local regulators’ requirements,” he says. “We also have to be in compliance with all the internal risk management parameters and controls on liquidity.” Trading can be subject to local regulations too – a licence to trade a particular product, for example – but “in general, in the last couple of years, the regulation changes in Asia are more on the liquidity management side. If you looked back a few years ago, the regulations were more on the trading side.”

And So confirms that regulation was not the only reason for the change.

“The financial crisis back in 2008 had a big impact on liquidity management,” he says. “The regulator imposed additional and more challenging requirements, but with or without that, bank management looked into the lessons they learned from the crisis in US and Europe and stepped up their liquidity management efforts.”

Some regulation is not specifically about what banks can do with surplus funds, but nevertheless has the effect of reducing available liquidity to invest. The most obvious example here is Basel III. These regulations should not, in themselves, be problematic for Asian banks. “Major economies in Asia Pacific have already implemented Basel III capital reforms in early 2013 as planned, and some countries applied more stringent regulations than those that the Basel Committee on Banking Supervision recommends,” says Standard & Poor’s in a recent report. “We expect most rated banks to be able to comply with the new requirements without significant difficulty, primarily because of their relatively strong core capital,” although S&P does expect banks in India and China to face challenges in maintaining or raising capital ratios to keep pace with growth in risk assets.

But even if Basel 3 doesn’t hurt Asian banks, it has knock-on effects. “The net impact is that if you want to be liquid, you need to maintain a liquidity buffer, which reduces the amount of funds you can deploy into the loan business, or put into investment, or support trading with,” says So, speaking of regulatory change generally rather than just Basel 3. “Since you want to preserve liquidity, you won’t be able to generate a very good return. So that will affect the revenue and cost of the bank.”

“The other implication is that whether it is driven by the regulator or the bank’s own initiative, most banks would now try to collect more customer deposits, especially long-term, sticky deposits,” So says. “So one natural consequence is that when banks compete with each other, they will pay a higher deposit rate, and therefore the funding costs of the bank go up. Both factors have a negative impact on the profit and revenue in the bank. The level of the impact depends on how liquid the bank was and tried to be.”

One further challenge is where to put the few remaining assets that are left over after meeting capital buffer requirements and the other short-term needs of the liquidity account. If one is matching deposits in Asian currencies, there is still a decent yield to be found. But dollars? Euros? Neither looks greatly attractive. “Today, generally dollar deposits are at relatively low levels given the expected weakness in the dollar or, conversely, strength of the local currency,” says Baker. “Couple lower dollar deposits with more dollar loan demand and that leads to a shrinking dollar liquidity book.”

Few see much merit in going for external advice in this environment. “Most banks manage these assets in-house and many simply place the deposits in the interbank market as they can get relatively high yields given dollar demand within their local banking systems,” says Baker. “Others invest some of the dollar funds in safe dollar assets such as government or agency debt.”

Euros, if anything, are worse. Given that banks are only ever likely to invest in the safe haven Eurozone debt rather than anything peripheral, the yields available are almost absurdly low: 150 basis points on 10-year bonds from Germany, where nominal yields on two-year bonds actually turned negative last summer. “When you go to university or look in a book you are told this is impossible,” says Gernot Griebling, an economist at LBBW in Stuttgart. “Nominal yields are at the lowest since the era of Bismarck, 140 year ago.”

This, in turn, creates further headaches for treasuries aiming to deploy surplus assets. “Yes, there’s a business impact,” says So. “If you collect deposits in a currency you cannot deploy for long, but into low yield assets, then the bank will end up losing money. So the bank has to consider: what should we do? Do we still want to collect in such currencies, or instead collect more in others? That will affect the bank’s deposit gathering strategy.”

This moribund environment for surplus investment looks likely to remain until several things happen: banks have a lengthy period of having met capital adequacy requirements in new regulation without a problem; a recovery in the US and Europe leads to rising yields and greater confidence in assets beyond the safe havens; and further growth in deposits. If those things happen, Asian bank treasuries may decide to deploy surplus funds in more daring asset classes, but today, the emphasis is on caution.