The Use of Economic Capital
Banking giants in emerging markets will probably do well in any likely economic scenario. Other banks face a more challenging future.
February 2009 | John Olivier, Chief Investment Officer
The first step is to create transparency on the current liquidity situation and provide the means to manage it. In particular, banks in emerging economies (India, Indonesia, Malaysia, Thailand, and Vietnam) must make sure they have full transparency on their underlying liquidity position and costs. But they also need to develop tools that can project the liquidity situation in the future. Stress testing this projection should be done via meaningful, management-oriented stress scenarios. There should be a clear separation of P&L arising from the bank’s underlying structural funding and liquidity position (and the risks associated with it) and the elements of tactical execution and risk taking on top of that. To achieve this, banks must enhance their modeling capabilities while incorporating good business judgment (for example, on stress-testing scenarios) and applying tools used by banks in other geographies.
Establishing a maturity ladder can help banks understand potential liquidity gaps and address them early on. To do so, banks need to make explicit assumptions about the development of the deposit base, for example, deposit growth (extrapolating from past trends and overlaying this with realistic assumptions) and the “stickiness” and behaviors of the deposit base. Similarly, players must model the asset side in more detail, looking at the growth of loan volumes and credit prolongations by understanding in more detail the underlying drivers and needs of loan takers. It is important here to differentiate by asset classes—for instance, rollover dates of credits and lines, optional ties, new deal pipelines, special-purpose vehicles, and structured- investment vehicles (for example, direct commitments, reputational risks). It is also important to offer greater transparency on the underlying profit and loss, for example, by establishing a clear liquidity account for all liquidity- and funding-related transactions.
Once banks have established this transparency internally, they must make sure that external stakeholders are adequately informed. This holds true for banks in India, Indonesia, Malaysia, Thailand, and Vietnam. Additionally, banks must establish a limit system throughout the organization for liquidity and funding use across business units and products in order to confine the overall use of liquidity and funding within the organization. In setting up these limits, a necessary first step is to review portfolios for unused liquidity and funding potential in order to arrive at realistic limit sizes.