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COVID-19: Sustaining Liquidity/Funding Management and Treasury Operations in All Scenarios


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As COVID-19’s international spread has accelerated, markets have started to price in epidemic-related risks. This paper provides a four-step approach that can enable executives to quantify impacts and define mitigating actions, helping them tackle near-term (crisis management) and long-term (structural liquidity management).

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COVID-19: Sustaining Liquidity/Funding Management and Treasury Operations in All Scenarios

  1. 1. White Paper COVID-19: Sustaining Liquidity/Funding Management and Treasury Operations in All Scenarios Matteo Coppola, Lorenzo Fantini, Michele Rigoni, Pascal Vogt March 2020
  2. 2. 1 BOSTON CONSULTING GROUP March 2020 hile the COVID-19 outbreak appears to be plateauing in Greater China, it has reached an inflection point elsewhere, characterized by the emergence of multiple epicenters. More than 140 countries have been affected, compared with around 20 in mid-February, and infection rates in many are rising fast. As COVID-19’s international spread has accelerated, markets have started to price in epidemic-related risks. Equity markets have posted some of the biggest daily declines since the 2007 financial crisis. Based on the experience of previous outbreaks (MERS in 2014, 2015, and 2016 or the Spanish flu in 1919 and 1920), the virus is likely to strike in several waves, suggesting that containment measures will be only partially effective until the release of a vaccine, which is currently not expected before Q1 2021. In this context, the crisis could last for another year and the risk of recession is real, although it is too early to call given financial market volatility is mostly being driven by uncertainty. Several central banks have taken action to shore up the financial system and offset an economic slowdown. The European Central Bank (ECB) on March 12 announced a number of measures to ensure that its directly supervised banks can continue to fulfil their role in funding the real economy. In particular:  Banks can make full use of their liquidity buffers. The European banking sector has built up significant liquidity reserves. The ECB will allow banks to operate temporarily below the minimum level of the liquidity coverage ratio (LCR).  Banks can get relief on Pillar 2 capital requirements. They can make use of hybrid capital instruments that do not qualify as Common Equity Tier 1 (CET1) capital, for example Additional Tier 1 or Tier 2 instruments, to meet Pillar 2 requirements set to come into effect from January 2021. Based on historical evidence, a V-shaped scenario – in which a GDP hit is followed by a rebound, with no long-term loss of output – is most likely. However, more pessimistic scenarios remain possible – especially in today’s interconnected world – and even a relatively speedy rebound may have long-lasting impacts on consumer behaviors, value chains, politics, and organizations. To safeguard stability and respond appropriately, CFOs, treasurers and CROs need a clear understanding of how liquidity/funding management and the treasury operating model may be impacted. A four-step approach can enable executives to quantify impacts and define mitigating actions, helping them tackle near-term (crisis management) and long- term (structural liquidity management) challenges. (See Exhibit 1). W
  3. 3. 2 BOSTON CONSULTING GROUP March 2020 Exhibit 1: Four key steps in a scenario-based approach  Step 1 – Vulnerability analysis. Assess the short-term vulnerability of the operating model and the bank’s liquidity and funding position.  Step 2 – Scenario design. Design scenarios to assess the medium- to long-term impact on both operating model (e.g. increasing employee absence) and liquidity and funding positions (e.g. substantial closure of short-term repo markets)  Step 3 – Impact assessment. Derive the impact on (i) business activity/volumes, (ii) treasury operating model and (iii) liquidity /funding financial impacts.  Step 4 – Trigger-based structural actions. Prepare decisive trigger-based mitigation actions (e.g. change governance/reporting lines for capital markets swap desks). Step 1 – Vulnerability Analysis Banks should consider two dimensions when assessing the vulnerability of treasury activities:  COVID-19 risk – driven for example by remote vs. on-premise working, presence of backup facilities, need for concentration of FTEs in physical spaces, time- criticality. … … … 1. Vulnerability analysis 2. Scenario Design 3. Impact assessment 4. Trigger-based structural actions 4 steps for a structural scenario-based action planning Business impact Operating model impact Liquidity & funding impact Scenario A Scenario B Scenario … KPIA1 KPIA… KPIB1 KPIB... KPI… KPI… Clients draw committed credit lines …Small team for Treasury hedge execution Increasing funding spreads BusinessOperationFinancial … …Safeguard retail deposit volumes … …Change governance for CM swap desk Free-up additional collateral Opportunities
  4. 4. 3 BOSTON CONSULTING GROUP March 2020  Necessity of any activity in crisis mode – driven for example by the regulator’s expectations for continuity. The treasury function faces a range of specific vulnerabilities emanating from the COVID- 19 crisis. (See Exhibit 2). For example, remote working is often difficult for a trading desk – remote access is usually limited to few employees. Additional fragmentation (beyond emergency trading rooms on-site) usually introduces inefficiencies and can hinder the bank’s ability to execute trades under internal compliance policies. Exhibit 2: Structural assessment of treasury vulnerability Project work should be carefully prioritized. It may be that some projects can be descoped or even postponed. A rigorous assessment should take into consideration, i) the level of commitment and obligations to regulators and internal stakeholders (board, senior management, internal audit), and ii) the level of risk exposure generated by the project (e.g. financial, reputational). For monitoring and reporting activities, a more differentiated approach is required. Some activities can be deprioritized if resources are scarce (e.g. detailed analysis of new asset volumes). Others are critical, including monitoring of liquidity and funding positions (including buffer volumes, open credit lines, impact on money market and repo operations, short-term issuance programs, and potential deposit outflows). For many, this will be familiar from the last financial crisis. Treasury activity analysis High Low HighLow Covid 19 risk of activity Necessity of activity in crisis mode 1 Money Market / Repo Execution functions 2 Liquid asset buffer 3 Equity issuance 4 Funding issuance 5 Investment portfolio 6 Swap execution 1 Liquidity Management Steering tasks 2 Funds-Transfer-Pricing 3 Analytics / modeling 4 Hedge-Accounting 5 Stress testing 6 Recovery planning 7 Investor relations 8 IT related project work 12 3 4 5 6 12 3 4 5 6 7 8 9 Other project work 10 Reporting 10 9 10 Focus on crisis relevant reporting
  5. 5. 4 BOSTON CONSULTING GROUP March 2020 Step 2 – Scenario Design While tactical short-term measures can partially restore day-to-day activities, they should be seen as the first step in a concerted effort. To build resilience, organizations should swiftly move to a scenario-based approach. Scenario design should start with the identification of two/three macro scenarios relating to the spread of the contagion. As in any scenario-building exercise, there should be two macro types:  A general health-related scenario, often used by researchers and medical experts to describe the spread of diseases based on aggregate statistics (e.g. number of infected people, contagion curve impacting treasury staff in key activities).  An event-based scenario, which is idiosyncratic and relates to specific triggering events (e.g. quarantine of a specific area, expected drop in volumes). We recommend starting with a limited number of these high-level scenarios and then translating them into treasury-specific sub-scenarios, based on a narrative that comprehensively captures the key vulnerabilities identified in the previous step. A few simplified examples: 1. Pressure on the liquidity buffer: o Potentially lower inflows (from LCR point of view) from suspended mortgage payments (e.g. Italy), deterioration of credit portfolio and defaults on loans, lower volume of secured lending transactions due to scarcity of underlying securities. o Potentially higher outflows (from LCR point of view) due to evolution of contingent liabilities (higher drawing of committed credit lines), deposit withdrawals (in particular for lower-rated, lower-capitalized banks), higher margin calls on derivatives, less secured funding backed by level 1 assets, due to market scarcity – more with level 2 and below, leading to higher haircuts. 2. Funding spreads increase and funding markets shut down: o Interbank and repo markets dry-up; good quality collateral gets scarce, even with central bank intervention (muted impact of Fed interventions in the repo market). o Senior unsecured and hybrid capital instruments: new issuance levels drop; refinancing spreads increase drastically.
  6. 6. 5 BOSTON CONSULTING GROUP March 2020 o Covered bond collateral exhausted, not enough supply of new mortgages. Virtually any financial risk (and some non-financial risks) can turn into liquidity risk. The most critical of these should be accounted for in scenario modeling. These might include credit risk reducing cash inflows, counterparty risk exponentially increasing liquidity risk, and interest rate volatility undermining the liquidity of a bank’s investment portfolio due to increasing haircuts. It is important that each scenario is assigned a qualitative likelihood (e.g. high, medium, or low) and, more importantly, a set of leading KPIs (e.g. size of liquidity buffer available for the next N working days) – and thresholds - that can highlight potential changes in the likelihood of each scenario. Monitoring of KPIs against a set of predefined thresholds will provide early warning signals relating to which scenarios are more likely and guide remediation strategies (see below). They should be closely and regularly monitored and reported to senior management, the board and risk/audit committees, which should ensure adequate oversight of the process. Step 3 – Impact Assessment The next step is to identify the potential economic impact of each scenario. To simplify and structure this step, it makes sense to group impacts in the same categories as used in the vulnerability analysis:  Business activity/volumes: The level of potential decline in sales or trading volumes will depend on the level of disruption (e.g. to revenues, earnings) due to loss of business volumes/customers and/or lower levels of transactions. It can be measured through quantitative (e.g. deterministic or stochastic simulation/stress testing) or qualitative metrics (such as loss of reputation). Once the business impact has been estimated, the CFO, treasurer and CRO should jointly assess the impact on liquidity/funding management.  Treasury operating model. This will depend on the number and relevance of the impacted functions. We recommend banks structure the impact assessment in line with i) necessity of treasury activities in crisis mode, and ii) risks posed by the COVID-19 epidemic. Clearly, a scenario affecting several critical functions will have a more severe impact.  Liquidity/funding financial impact. Potential impacts include a structural liquidity shortage or structurally increased funding costs, leading to lower profits or losses. We recommend treasurers define and calculate a few KPIs (e.g. liquidity cushion
  7. 7. 6 BOSTON CONSULTING GROUP March 2020 after N days, funding need in the next N months; regulatory metrics like LCR and NSFR would play a second order role) to summarize the severity of each scenario, combining all impacts above and allowing reviewers to compare scenarios and their impacts over time. A reporting dashboard is a powerful tool that can help managers gauge required actions and their urgency. Step 4 – Trigger-based Structural Actions The ECB regards the treasury function as “critical”, which means it is required by law to continue operating. This fact alone highlights the need to respond to any significant impact derived from crisis scenarios. As in a traditional risk appetite framework, contingency actions should be activated when there is a breach of early warning levels for identified triggers. Mitigating solutions should be defined consistent with the categories described in the previous sections. They should be more or less aggressive depending on the likelihood and severity of the scenario and should comprehensively cover:  Operating model stability actions. These may include: o Diversification (including on a geographical basis and within buildings) of key treasury activities – potentially working across time zones and backups for critical activities (even multiple ones). o Limitations and tracking of contact among employees responsible for critical functions - when required to work on premise. o Provision of protective or smart working equipment, part-time working options, reliable remote connection options, Still, some treasury activities will not be suited to smart working (e.g. market access) and companies need to plan ahead. o Change in governance, for example bringing money market and repo desks fully under treasury control (if they are not already). o New IT infrastructure will be required if 50%-60% of people work remotely.  Liquidity and funding stability actions. These may include: o A switch to “amber code” liquidity management, with more frequent evaluation of liquidity buffers and treasury portfolios, and related reporting to senior management. o The activation of ad-hoc contingency measures, evaluating the trade-off between liquidity and profitability – for example, increase liquid asset buffers for as long as possible to cover all scenarios analyzed in steps 2 and 3.
  8. 8. 7 BOSTON CONSULTING GROUP March 2020 The more rigorous the approach to the four scenario-planning steps, the more resilient the treasury organization will be. Senior management should plan carefully, so that effective remediation steps can be put in place quickly once a scenario (or a variant of it) materializes. Finally, while it is paramount in a crisis to manage uncertainty, there may also be an opportunity to add value:  In an adverse scenario, a more liquid bank (not necessarily better capitalized) can pick-up less liquid assets at discounted prices. Weaker banks may be forced to shed Level 2 and below assets for cash.  There is a potential benefit for banks that are perceived as “stronger” in the long- run – they will likely see a deposit influx, as seen during the last financial crisis. Conclusion In light of the spread of COVID-19, bank treasurers (along with CFOs and CROs) must refocus on maintaining operating model stability and safeguarding the bank’s liquidity and funding position. Equally, it is vital that they communicate clearly, both internally (providing assurance and helping to shape culture and behaviors) and externally (reassuring stakeholders that the company understands its potential vulnerabilities and has structural solutions to address them). A lack of communication will cause stakeholders to assume the worst (significant impact and no contingency actions). In the midst of a period of uncertainty, there is little value in hesitancy. Leaders must proactively manage their response and work with determination toward the best possible outcome. Matteo Coppola Lorenzo Fantini Michele Rigoni Pascal Vogt Matteo Coppola is a senior partner and managing director in the Milan office of Boston Consulting Group. Lorenzo Fantini is a partner and managing director in the firm’s Milan office. Michele Rigoni is a principal in the firm’s Milan office and Pascal Vogt is a partner and director in the firm’s Cologne office. You may contact the authors by e-mail at:
  9. 9. 8 BOSTON CONSULTING GROUP March 2020 About BCG Boston Consulting Group partners with leaders in business and society to tackle their most important challenges and capture their greatest opportunities. BCG was the pioneer in business strategy when it was founded in 1963. Today, we help clients with total transformation—inspiring complex change, enabling organizations to grow, building competitive advantage, and driving bottom-line impact. To succeed, organizations must blend digital and human capabilities. Our diverse, global teams bring deep industry and functional expertise and a range of perspectives to spark change. BCG delivers solutions through leading-edge management consulting along with technology and design, corporate and digital ventures—and business purpose. We work in a uniquely collaborative model across the firm and throughout all levels of the client organization, generating results that allow our clients to thrive.