Intraday Liquidity Risk Management

After completing this reading, you should be able to:

• Identify and explain the uses and sources of the Intraday liquidity
• Discuss the governance structure of the intraday risk liquidity management
• Differentiate between methods for tracking intraday flows and monitoring risk levels.

Intraday liquidity refers to cash funding that can be accessed at any point during the business day to enable banks to continue processing transactions. This can include the interbank fund markets, wholesale money markets, and intraday credit lines provided by central banks or financial market utilities (FMUs). On the other hand, intraday liquidity risk is the risk that a bank or FMU is unable to cover a payment or settlement obligation at the expected time due to inadequate liquid funds (cash), also known as settlement risk.

Banks may face a shortage of liquidity during the day. This is because certain market conditions serve to institutionalize intraday overdrafts. For example, a bank can borrow fed funds in the inter-bank market any time within the business day with a delivery of funds occurring almost immediately, but the return of borrowed funds usually takes place as a first-order item the following morning. Even though the transaction is priced as a one-day loan, the borrower has the use of the funds for less than twenty-four hours. Moreover, the provision of intraday credit to clients causes a shortage in the bank’s liquidity.

Uses and Sources of Intraday Liquidity

Uses of Intraday Liquidity

Outgoing wire transfers: These are typically the essential use of intraday liquidity. Payment lasts the entire business day and follows a reasonably predictable pattern. Large banks “throttle” outgoing payments and closely monitor incoming credits to ensure that they do not exceed their debit cap. Most large-value payment systems (LVPSs) and some other payment, clearing, and settlement systems (PCSs) have hard controls that prevent participants from exceeding their intraday credit limits.

Settlements at Payment, Clearing, and Settlement (PCS) Systems: Most PCS systems have a single settlement per day, which is done majorly in the late afternoon timeframe. These systems may either serve as a source or use of funds reliant on the net position of a participant on any given day. They can be forecast for securities that have multi-day settlements (e.g., T+3) and are more difficult for same-day settlement activity.

Funding of Nostro accounts: This entails transferring cash to a correspondent bank for services provided. Banks manage the cash they place in a correspondent bank account to a target average monthly balance as part of the return for providing banking services. The account funding position may serve as a basis or use of funds for the bank’s overall liquidity profile. However, this depends on the net position of the activity flowing in the account on that given day. Nostro account balances are restocked or drawn down every day.

Collateral pledging: This pertains to banking activities that require a bank to earmark and set aside collateral. Such activities include over-the-counter capital markets trading and deposits of certain public funds. Everyday use of intraday funding is to acquire extra collateral to care for an increasing liability or as a result of a mark-to-market induced margin call. These collateral positions are adjusted daily.

Asset purchases/funding: Intraday liquidity is also utilized to fund other balance sheet assets. These assets may include securities purchases for the investment portfolio, client loans, and fixed asset purchases.

Sources of Intraday Liquidity

There are several sources of intraday funding accessible to the bank treasurer. However, each of these sources differs in its contribution to overall funding from day-to-day. Nevertheless, each source is instrumental in the overall funding landscape.

The typical sources of intraday liquidity include:

Cash balances: This is the most common source of intraday liquidity; it is the starting cash held on the bank’s balance sheet at the beginning of the day. This cash includes deposits at the central bank and a correspondent bank Nostro accounts. Unlike bank clients, the bank treasury determines the level of closing/start of day cash balances. The bank activity can be forecasted with 1 to 2 days’ notice, whereas the client payment activity is more difficult to predict.

Incoming funds flow: Incoming flows from payments and FMU settlements form the largest source of intraday funding during the normal market function. Some of these inflows, including LVPS payments, are real-time while credits are batch-oriented; an example is the net settlements with clearinghouses, and retail payment systems, among others. We can forecast bank activity with 1 to 2 days’ notice. However, client payment activity is more difficult to predict. FMU credit can be forecast for securities that have multi-day settlements (e.g., T+3). Forecasting is relatively tricky for same-day settlement activity

Intraday credit: This refers to a credit line or overdraft permitted during business hours and covered by close of business. Lines are often uncommitted and provided without interest charges. Central banks are the largest sources of intraday credit for the banking system, and their borrowing terms change across jurisdictions. Additionally, FMUs and other banks may also provide intraday credit.

Liquid assets: These are assets that can be converted quickly into cash. They include cash, money market deposits, and short-term government debt (e.g., T-Bills). The clients may be sources of liquidity in converting liquid assets into cash, for example, in a repo transaction.

Overnight borrowings: These borrowings provide quick intraday liquidity for a bank. They include Fed funds, London Interbank Offered Rate (LIBOR), and Eurodollar deposits. Note that these kinds of borrowings are not repaid on the same day. Hence, they remain on the borrower’s balance sheet overnight. The bank treasury must gauge the possible cost of having excess liquidity at the end of the day versus the risk of being unable to complete the current day’s business or even experiencing reputational risk exposure from delayed transactions due to breaking a daylight overdraft limit.

Other term funding: A bank can tap into other funding sources such as Federal Home Loan Banks (FHLB) borrowings and term repos if the lenders are in a capacity to offer funding at a time of day that is appropriate for the bank’s intraday funding needs.

Furthermore, the bank does this only if it needs longer-term funding, like for one week, one month, and so on. Client supply of term funding tends to be reasonably predictable, with low volatility. This type of borrowing is generally viewed as an incremental factor to include in each day’s liquidity positioning ledger rather than a consistent source of intra-day funding.

Governance Structure of the Intraday Risk Liquidity Management

In this section, we look at an overview of the leading practices for managing intraday liquidity risk at large banks.

Governance of Intraday LRM

All risk management contexts begin with a governance structure that outlines the roles and duties of various banks. The characteristics of a sound governance structure for overseeing intraday liquidity risk include the following:

Active risk management: Intraday liquidity risk is recognized as a cost and is not as actively managed strictly as other kinds of enterprise risk or liquidity risks. The leading banks with vast volumes of PCS have mastered the art of understanding and working to decrease their intraday liquidity risks. Such banks categorize settlement and systemic risks as part of their risk arrangement; they further include them critically into the firm’s risk appetite framework.

Integration with risk governance: This involves the integration of the oversight of intraday risk management into the bank’s overall risk oversight structure.

Risk assessment: Intraday liquidity risk is combined into the risk classification at major institutions and is treated as a factor of risk self-assessments — this analysis aids in identifying and evaluating settlement risks about existing and potential new products and operational processes. The line of business and risk management committee reviews the soundness of controls in mitigating settlement risk.

Risk measurement and monitoring: Leading institutions monitor their intraday liquidity risk using two perspectives:

• The amount of intraday credit the institution is extending to clients.
• The amount of intraday credit the institution utilizes.

From the first perspective, systemically important financial institutions (SIFIs) with huge transaction banking and capital markets, businesses have invested substantially in recent years to elevate their capacity to compile and monitor real-time cash positions for their clients. Institutions with these capacities can pass on the intraday overdraft charges they get from central banks onto clients, given that the industry moves in that direction. The second perspective should give a complete view of all intraday credit used by an institution. However, the unavailability of data and data aggregation makes this perspective more challenging.

Methods for Tracking Intraday Flows and Monitoring Risk Levels

Measurement of Intraday Liquidity

In this subsection, we delve into the commonly used measures significant for apprehending and monitoring the bank’s intraday liquidity risk. Institutions need to set risk limits and do consistent tracking against these measures.

Measures for Understanding Intraday Flows

Total Payments

A bank should store crucial information following a transaction in a data warehouse. Information regarding a payment transaction, such as payment amount, time received or originated, times for each processing step in the payment workflow, routing information, payer, and payee, among others, is essential for analysis.

Compiling this information aids in drawing insights such as the trend in payment volumes over time for doing correlation analysis, the net position in the settlement account at any time of day, filtered by payment type, and total payments sent and received for bank activity among others.

Other Cash Transactions

A bank should monitor intraday and end-of-day settlement positions at every financial market utility in which it participates. Furthermore, the bank should maximize the volume of transaction-level detail taken and stored for further analysis.

Settlement Positions

If a bank has no complete data for reconstructing account positions at any time of the day, it should at least keep data on its settlement positions with all its FMUs. These critical, deadline-specific payments are critical to managing intraday liquidity and systemic risk. Therefore, banks should track trends in settlement positions and correlate them with external market factors to enhance their capacity to predict future liquidity requirements in time.

Time-sensitive Obligations Like Settlement Positions

These transactions need completion at a time of the day, just like settlement positions. Failure to settle time-sensitive obligations can lead to a financial penalty or other negative consequences. Therefore, a bank should track the volume and settlement patterns of these time-sensitive obligations by recording the amounts and deadline times.

Total Intraday Credit Lines to Clients and Counterparties

A bank risk manager must look after the bank’s intraday liquidity risk needs to understand the potential and actual amounts of intraday credit the bank is extending to clients and counterparties. These intraday credit lines can be committed and disclosed to the client in some cases, while in other cases the lines are uncommitted and undisclosed. In addition to the credit lines, the bank should have data on average and peak usage, and the ability to model activity at the client and portfolio levels.

Total Bank Intraday Credit Lines Available and Usage

Regulators anticipate financial institutions to understand and control the size of systemic risk they pose to the overall financial system among risks posed to taxpayers and industry-funded insurance plans. In that analysis, the amount of intraday credit that a bank depends on and the maximum amount of intraday borrowing it can draw down is very crucial. This data takes the amount of committed and uncommitted intraday credit an institution has at its disposal, preferably across all its cash and settlement accounts.

Measures for Quantifying and Monitoring Risk Levels

Daily Maximum Intraday Liquidity Usage

Daily maximum intraday liquidity usage is a measure of the bank’s usage of an intraday credit extension. It is the ratio of the day’s most significant net negative balance relative to the size of the committed or uncommitted credit line. The peak and average of this metric are monitored over some time. At a minimum, this measure should be tracked for every cash account held at the central bank, FMUs, and correspondent banks. A bank should also track its consolidated position across all accounts between which liquidity can be readily transferred intraday without restrictions to get an accurate picture of its intraday liquidity usage. This is done for accounts with the same currency and connected to a standard payment system but can be done for several currencies and in different jurisdictions if cash and collateral are freely transferred between the jurisdictions intraday.

Intraday Credit Relative to Tier 1 Capital

This measure is a broad representation of the intraday settlement risk caused by a bank. It should be tracked for both total intraday credit and unsecured intraday credit, existing and used, according to the perception that posting high-quality collateral mitigates intraday settlement risk. Moreover, available unsecured intraday credit relative to an institution’s tier 1 capital is also a measure of the unintended systemic risk that the institution causes to the financial system.

However, it is a weak measure. Using time-series analysis on such measures as well as horizontal comparisons to other institutions would provide bank risk managers with an understanding of the relative systemic risk of their business model as well as fluctuations in their risk profile over time.

Client Intraday Credit Usage

This measure is obtained by comparing a client’s peak daily intra-day overdraft to the established credit line. It is essential in tracing the total intraday credit exposures as it furnishes a bank with an indicator of the necessary liquidity required to support its clients’ business activities. Besides, tracking the averages, volatility, and correlation of these measures to other money market indicators gives useful information for establishing how client activity affects its capacity to manage its intraday liquidity.

Payment Throughput

It is a measure that tracks the percentage of outgoing payment activity relative to the time of day. For FMU participating banks, it is useful to actively measure and to track the flow of outgoing payment transactions relative to total payments or time markers for reasons such as:

1. Tracking its volume patterns aid in ensuring that all the day’s payments are processed on a timely basis.
2. Meeting FMU requirements for submitting a target percentage of payments by a deadline.
3. Helping the bank identify and track its peak periods over time and the correlation of this activity with its intraday liquidity on hand and intraday credit usage.

Additionally, a bank can monitor its top intraday credit usage concerning the total volumes with an FMU to get an indicator of the effectiveness of the FMU’s usage of daylight credit. Different system rules and operating models are used by FMU, leading to disparities in how effectively they use intraday liquidity. For a bank to redirect payment flows as a tool to manage intraday liquidity needs, it should understand these differences, assuming it has the essential operational skills.

Role of Stress Testing

The previous indicators are significant in understanding and tracking a bank’s need for and use of intraday credit under business as usual. It’s worth noting that intraday liquidity requirements and usage can vary significantly during periods of market stress. Consequently, a bank that frequently depends on intraday credit should model the effect of various events on its requirements and the availability of intraday liquidity.

Despite that, the banking industry has, over time, established useful stress tests of overall liquidity management that have helped in developing liquidity contingency plans. In spite of this, the industry, through moderators, needs to extend these capabilities to intraday position modeling. Stress testing of intraday liquidity risk management may result in numerous advantages for a bank. Apart from the empirical results gained from these advantages, interactions and discussions, brainstorming, and other critical thinking that senior management engages in when stress testing may be useful.

Practice Question

Lending institutions use two perspectives in monitoring their intraday liquidity risk. Which of the following options correctly states the two perspectives?

A. The amount of intraday credit the institution is extending to clients and the amount of intraday credit the institution utilizes.

B. The amount of intraday credit the institution is extending to clients and the risk assessment.

C. Active risk management and the amount of intraday credit the institution utilizes.

D. The amount of intraday credit the institution is extending to clients and the amount of debts the institution pays.

The correct answer is A.

B is incorrect as risk assessment is a broad concept and isn’t specifically one of the two primary perspectives for monitoring intraday liquidity risk. The main focus is on the credit extended and utilized.

C is incorrect because while active risk management is essential for lending institutions, it is not one of the two primary perspectives used in monitoring intraday liquidity risk. The emphasis is on the intraday credit aspects.

D is incorrect because the concern isn’t about the amount of debt the institution pays, but rather the intraday credit they extend and use within a business day.

Things to Remember

• Intraday liquidity risk pertains to an institution’s ability to manage its liquidity positions within the span of a business day.
• The two primary perspectives for monitoring intraday liquidity risk are: the amount of intraday credit extended to clients and the amount of intraday credit an institution uses.
• Having a clear grasp of both credit extended and utilized is crucial to ensure smooth operations and prevent potential liquidity shortfalls during the day.
• Lending institutions need to be proactive in monitoring these metrics to ensure they remain within acceptable thresholds and respond to any emerging risks promptly.