Banks must capitalize on the benefits of integrating interest risk and liquidity risk management – beyond compliance
The current stress in the banking system – with the collapse of Silicon Valley Bank, Credit Suisse, and whispers of a global banking crisis – is a stark reminder of the necessity to manage interest rates and liquidity risk with an integrated approach. Reviewing these processes for many banks will no longer remain optional, as regulators are preparing to increase scrutiny on risk management processes and tools.
In this article, we will explore how banks can turn compliance into an opportunity to increase profitability and improve decision-making by choosing an integrated, real-time approach to risk management.
What’s the connection between interest rate and liquidity risk management?
While often managed in silos, there is a strong correlation between interest rates and liquidity risk management. This is because changes in interest rates can affect a bank’s liquidity position. For example, if interest rates rise, the value of a bank’s assets may decline to make it more difficult for the bank to access funding in the market. Additionally, higher interest rates can increase the cost of funding for a bank, reducing its profitability and potentially leading to liquidity issues.
Hence, effective management of interest rate risk is essential for managing liquidity risk. Banks must have effective interest rate risk management strategies in place to ensure that they can manage changes in interest rates and maintain their liquidity position. This may involve hedging strategies, diversification of funding sources, and effective cash management practices.
Bank regulatory scrutiny ahead
With US banks sitting at $620 billion in unrealized losses from repriced securities at the end of 2022, especially tier 2 and tier 3 banks can expect regulators to apply additional scrutiny on risk management processes and tools moving forward.
Banks are required to meet LCR and NSFR requirements and comply with operational risk regulations such as BCBS144 Principle 8, and BCBS 248.
To remain compliant banks must:
- Have effective cash management processes in place. This ensures that they can monitor their cash positions and cash flows in real-time, actively manage their intraday liquidity positions and respond to any liquidity issues promptly.
- Conduct regular stress tests to assess their liquidity risk and ensure that they have adequate resources to withstand potential shocks.
- Provide regular reports to regulatory authorities, including daily reporting of their intraday liquidity position.
Can banks meet the risk management requirements?
Based on our implementation experiences, banks since the financial crisis have focused on becoming compliant by implementing risk management processes supported by point solutions. They are often developed in-house for department-specific needs. This creates knowledge and data silos between departments, therefore, limiting a bank’s capability to assess and manage the interest rate and liquidity risk across treasury, funding, risk, and operations in real-time.
Creating an opportunity from compliance
Apart from the risk of failing to comply and becoming subject to fines and other penalties, banks are missing significant business opportunities. Below are some benefits of using an integrated, real-time interest rate and liquidity risk management solution with a single reconciled data source.
Integrated interest rate and liquidity risk management can help banks to optimize their interest income and reduce interest expenses, while simultaneously ensuring liquidity with reduced cost of funding for any given time band.
Integrating these two areas of risk management can help banks to make better-informed decisions about their funding sources, interest rate exposure, and overall risk profile. This can help to improve overall business performance and reduce the risk of financial losses.
Boost customer satisfaction
Effective risk management can help to reduce the risk of financial distress and ensure long-term financial stability. Because of this, banks can increase customer confidence, avoid bank runs and enhance customer satisfaction.
Of course, the implementation of an integrated, real-time interest rate and liquidity risk solution with a single reconciled data source, such as SAP Fioneer’s Finance & ESG platform, requires time and effort. But a ‘walk, before run’ approach, focusing on immediate business needs first can ensure a minimum impact to business while starting on the journey.
Will improving risk management processes and tools help to avoid another collapse?
It’s hard to say. Improved processes and tools may not be able to correct or undo the consequences of bad investment decisions. However, banks will be pushed – both by stakeholders and regulators – to improve decision-making and manage the stress created in the banking system. These can be due to asset repricing, yield curve inversion correlated with interest rate changes, and multiple other factors resulting in another financial system contagion, otherwise beyond a bank’s control. Integrated, real-time solutions for interest and liquidity risk management can help weather the economic storm and serve as a base for better decisions moving forward.