An increasing number of policy makers and regulators have embedded the recommendations in industry guidance and laws. In this article we summarize the TCFD recommendations, taking into account the additional guidance that has been provided by the TCFD since the original recommendations were published.

Today’s interest rates are positive, the yield curve relatively flat and, in some currencies, even (slightly) inverse. The rise in interest rates poses a significant challenge for banks. This challenge involves managing the impact that rising rates have on the bank’s IRRBB key risk metrics as well as new EBA regulation related to supervisory outlier tests (SOTs) for IRRBB.

With every improvement, fraudsters look for and find new opportunities to exploit. When the opportunity arises, some people see a big incentive or pressure to commit fraud, and most will be able to justify to themselves why it is acceptable to commit fraud (as shown in the Fraud triangle – Figure 1). Unfortunately, the impact of fraud on organizations, individuals and society in general is substantial.

Challenges with VaR models in a turbulent market​

With recent periods of market stress, including COVID-19 and the Russia-Ukraine conflict, banks are finding their VaR models under strain. A failure to adhere to VaR backtesting requirements can lead to pressure on balance sheets through higher capital requirements and interventions from the regulator.

VaR backtesting

VaR is integral to the capital requirements calculation and in ensuring a sufficient capital buffer to cover losses from adverse market conditions.​ The accuracy of VaR models is therefore tested stringently with VaR backtesting, comparing the model VaR to the observed hypothetical P&Ls. ​A VaR model with poor backtesting performance is penalised with the application of a capital multiplier, ensuring a conservative capital charge.​ The capital multiplier increases with the number of exceptions during the preceding 250 business days, as described in Table 1 below.​

Table 1: Capital multipliers based on the number of backtesting exceptions.

The capital multiplier is applied to both the VaR and stressed VaR, as shown in equation 1 below, which can result in a significant impact on the market risk capital requirement when failures in VaR backtesting occur.​

Pro-cyclicality of the backtesting framework​

A known issue of VaR backtesting is pro-cyclicality in market risk. ​This problem was underscored at the beginning of the COVID-19 outbreak when multiple banks registered several VaR backtesting exceptions. ​This had a double impact on market risk capital requirements, with higher capital multipliers and an increase in VaR from higher market volatility.​ Consequently, regulators intervened to remove additional pressure on banks’ capital positions that would only exacerbate market volatility. The Federal Reserve excluded all backtesting exceptions between 6th – 27th March 2020, while the PRA allowed a proportional reduction in risks-not-in-VaR (RNIV) capital charge to offset the VaR increase.​ More recent market volatility however has not been excluded, putting pressure on banks’ VaR models during backtesting.​

Historical simulation VaR model challenges​

Banks typically use a historical simulation approach (HS VaR) for modelling VaR, due to its computational simplicity, non-normality assumption of returns and enhanced interpretability. ​Despite these advantages, the HS VaR model can be slow to react to changing markets conditions and can be limited by the scenario breadth. ​This means that the HS VaR model can fail to adequately cover risk from black swan events or rapid shifts in market regimes.​ These issues were highlighted by recent market events, including COVID-19, the Russia-Ukraine conflict, and the global surge in inflation in 2022.​ Due to this, many banks are looking at enriching their VaR models to better model dramatic changes in the market.

Enriching HS VaR models​

Alternative VaR modelling approaches can be used to enrich HS VaR models, improving their response to changes in market volatility. Volatility scaling is a computationally efficient methodology which can resolve many of the shortcomings of HS VaR model, reducing backtesting failures.​

Enhancing HS VaR with volatility scaling​

The Volatility Scaling methodology is an extension of the HS VaR model that addresses the issue of inertia to market moves.​ Volatility scaling adjusts the returns for each time t by the volatility ratio σT/σt, where σt is the return volatility at time t and σT is the return volatility at the VaR calculation date.​ Volatility is calculated using a 30-day window, which more rapidly reacts to market moves than a typical 1Y VaR window, as illustrated in Figure 1.​ As the cost of underestimation is higher than overestimating VaR, a lower bound to the volatility ratio of 1 is applied.​ Volatility scaling is simple to implement and can enrich existing models with minimal additional computational overhead.​

Figure 1: The 30-day and 1Y rolling volatilities of the 1-day scaled diversified portfolio returns. This illustrates recent market stresses, with short regions of extreme volatility (COVID-19) and longer systemic trends (Russia-Ukraine conflict and inflation). 

Comparison with alternative VaR models​

To benchmark the Volatility Scaling approach, we compare the VaR performance with the HS and the GARCH(1,1) parametric VaR models.​ The GARCH(1,1) model is configured for daily data and parameter calibration to increase sensitivity to market volatility.​ All models use the 99th percentile 1-day VaR scaled by a square root of 10. ​The effective calibration time horizon is one year, approximated by a VaR window of 260 business days.​ A one-week lag is included to account for operational issues that banks may have to load the most up-to-date market data into their risk models.​

VaR benchmarking portfolios​

To benchmark the VaR Models, their performance is evaluated on several portfolios that are sensitive to the equity, rates and credit asset classes. ​These portfolios include sensitivities to: S&P 500 (Equity), US Treasury Bonds (Treasury), USD Investment Grade Corporate Bonds (IG Bonds) and a diversified portfolio of all three asset classes (Diversified).​ This provides a measure of the VaR model performance for both diversified and a range of concentrated portfolios.​ The performance of the VaR models is measured on these portfolios in both periods of stability and periods of extreme market volatility. ​This test period includes COVID-19, the Russia-Ukraine conflict and the recent high inflationary period.​

VaR model benchmarking

The performance of the models is evaluated with VaR backtesting. The results show that the volatility scaling provides significantly improved performance over both the HS and GARCH VaR models, providing a faster response to markets moves and a lower instance of VaR exceptions.​

Model benchmarking with VaR backtesting​

A key metric for measuring the performance of VaR models is a comparison of the frequency of VaR exceptions with the limits set by the Basel Committee’s Traffic Light Test (TLT). ​Excessive exceptions will incur an increased capital multiplier for an Amber result (5 – 9 exceptions) and an intervention from the regulator in the case of a Red result (ten or more exceptions).​ Exceptions often indicate a slow reaction to market moves or a lack of accuracy in modelling risk.​

VaR measure coverage​

The coverage and adaptability of the VaR models can be observed from the comparison of the realised returns and VaR time series shown in Figure 2.​ This shows that although the GARCH model is faster to react to market changes than HS VaR, it underestimates the tail risk in stable markets, resulting in a higher instance of exceptions.​ Volatility scaling retains the conservatism of the HS VaR model whilst improving its reactivity to turbulent market conditions. This results in a significant reduction in exceptions throughout 2022.​

Figure 2: Comparison of realised returns with the model VaR measures for a diversified portfolio.

VaR backtesting results​

The VaR model performance is illustrated by the percentage of backtest days with Red, Amber and Green TLT results in Figure 3.​ Over this period HS VaR shows a reasonable coverage of the hypothetical P&Ls, however there are instances of Red results due to the failure to adapt to changes in market conditions.​ The GARCH model shows a significant reduction in performance, with 32% of test dates falling in the Red zone as a consequence of VaR underestimation in calm markets.​ The adaptability of volatility scaling ensures it can adequately cover the tail risk, increasing the percentage of Green TLT results and completely eliminating Red results.​ In this benchmarking scenario, only volatility scaling would pass regulatory scrutiny, with HS VaR and GARCH being classified as flawed models, requiring remediation plans.

Figure 3: Percentage of days with a Red, Amber and Green Traffic Light Test result for a diversified portfolio over the window 29/01/21 - 31/01/23.

VaR model capital requirements​

Capital requirements are an important determinant in banks’ ability to act as market intermediaries. The volatility scaling method can be used to increase the HS capital deployment efficiency without compromising VaR backtesting results.​

Capital requirements minimisation​

A robust VaR model produces risk measures that ensure an ample capital buffer to absorb portfolio losses. When selecting between robust VaR models, the preferred approach generates a smaller capital charge throughout the market cycle. Figure 4 shows capital requirements for the VaR models for a diversified portfolio calculated using Equation 1, with 𝐴𝑑𝑑𝑜𝑛𝑠 set to zero. Volatility scaling outperforms both models during extreme market volatility (the Russia-Ukraine conflict) and the HS model in period of stability (2021) as a result of setting the lower scaling constraint. The GARCH model underestimates capital requirements in 2021, which would have forced a bank to move to a standardised approach.

Figure 4: Capital charge for the VaR models measured on a diversified portfolio over the window 29/01/21 - 31/01/23.

Capital management efficiency

Pro-cyclicality of capital requirements is a common concern among regulators and practitioners. More stable requirements can improve banks’ capital management and planning. To measure models’ pro-cyclicality and efficiency, average capital charges and capital volatilities are compared for three concentrated asset class portfolios and a diversified market portfolio, as shown in Table 2. Volatility scaling results are better than the HS model across all portfolios, leading to lower capital charges, volatility and more efficient capital allocation. The GARCH model tends to underestimate high volatility and overestimate low volatility, as seen by the behaviour for the lowest volatility portfolio (Treasury).

Table 2: Average capital requirement and capital volatility for each VaR model across a range of portfolios during the test period, 29/01/21 - 31/01/23.

Conclusions on VaR backtesting

Recent periods of market stress highlighted the need to challenge banks’ existing VaR models. Volatility scaling is an efficient method to enrich existing VaR methodologies, making them robust across a range of portfolios and volatility regimes.

VaR backtesting in a volatile market

Ensuring VaR models conform to VaR backtesting will be challenging with the recent period of stressed market conditions and rapid changes in market volatility. Banks will need to ensure that their VaR models are responsive to volatility clustering and tail events or enhance their existing methodology to cope. Failure to do so will result in additional overheads, with increased capital charges and excessive exceptions that can lead to additional regulatory scrutiny.

Enriching VaR Models with volatility scaling

Volatility scaling provides a simple extension of HS VaR that is robust and responsive to changes in market volatility. The model shows improved backtesting performance over both the HS and parametric (GARCH) VaR models. It is also robust for highly concentrated equity, treasury and bond portfolios, as seen in Table 3. Volatility scaling dampens pro-cyclicality of HS capital requirements, ensuring more efficient capital planning. The additional computational overhead is minimal and the implementation to enrich existing models is simple. Performance can be further improved with the use of hybrid models which incorporate volatility scaling approaches. These can utilise outlier detection to increase conservatism dynamically with increasingly volatile market conditions.

Table 3: Percentage of Green, Amber and Red traffic Lights test results for each VaR model across a range of portfolios for dates in the range: 13/02/19 - 31/01/23.

Zanders recommends

Banks should invest in making their VaR models more robust and reactive to ensure capital costs and the probability of exceptions are minimised. VaR models enriched with a volatility scaling approach should be considered among a suite of models to challenge existing VaR model methodologies. Methods similar to volatility scaling can also be applied to parametric and semi-parametric models. Outlier detection models can be used to identify changes in market regime as either feeder models or early warning signals for risk managers

More simply put, the EBA was asked to investigate whether the current prudential framework properly captures environmental and social risks. In response, the EBA published a Discussion Paper (DP) [1] in May 2022 to collect input from stakeholders such as academia and banking professionals.

These risks stem from the transition towards a low carbon economy and from the physical risks of damages due to extreme weather events. To address climate-related financial risks within the banking sector, the Basel Committee on Banking Supervision (BCBS) established a high-level Task Force on Climate-related Financial Risks in 2020. It contributes to the BCBS’s mandate to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.

Both the BCBS’s Core principles for effective banking supervision¹ and the Supervisory Review and Evaluation Process (SREP) within the existing Basel Framework are considered sufficiently broad and flexible to accommodate additional supervisory responses to climate-related financial risks. It was felt, however, that supervisors and banks could benefit from the publication of the Principles for the effective management and supervision of climate-related financial risks². Through this publication, the BCBS seeks to promote a principles-based approach to improving risk management and supervisory practices regarding climate-related financial risks. The document contains principles directed to banks and principles directed to supervisory authorities. In this article, we present an overview of the principles directed to banks.

The BCBS published a draft of their Principles in November 2021. During the consultation phase, which lasted until February 2022, banks and supervisors could provide feedback. The BCBS incorporated their feedback in the final version of the Principles that were published in June 2022.

Principles for the management of climate-related financial risks

In total, twelve bank-focused principles are presented and grouped in eight categories. Each of the eight categories is briefly discussed below:

Corporate governance – Principles 1 to 3

The principles related to corporate governance state that banks first need to understand and assess the potential impact of climate risks on all fields they operate in. Subsequently, appropriate policies, procedures and controls need to be implemented to ensure effective management of the identified risks. Furthermore, roles and responsibilities need to be clearly defined and assigned throughout the bank. To successfully manage climate-related risks, banks should ensure an adequate understanding of climate-related financial risks and as well as adequate resources and skills at all relevant functions and business units within the bank. Finally, the board and senior management should ensure that all climate-related strategies are consistent with the bank’s stated goals and objectives.

Internal control framework – Principle 4

The fourth principle within the internal control framework subcategory requires banks to include clear definitions and assignment of climate-related responsibilities and reporting lines across all three lines of defense. Further requirements are then presented for each line of defense.

Capital and liquidity adequacy – Principle 5

After the identification and quantification of the climate-related financial risks, these risks need to be incorporated into banks’ Internal Capital (and Liquidity) Adequacy Assessment Process (ICLAAP). Banks should provide insights in which climate-related financial risks affect their capital and liquidity position. In addition, physical and transition risks relevant to a bank’s business model assessed as material over relevant time horizons, should be incorporated into their stress testing programs in order to evaluate the bank’s financial position under severe but plausible scenarios. Furthermore, the described incorporation in the ICLAAP to handle such financial risks, should be done iteratively and progressively, as the methodologies and data used to analyze these risks continue to mature over time.

Risk management process – Principle 6

The sixth principle connects to the previous one, as it states that a bank needs to identify, monitor and manage all climate-related financial risks that could materially impair their financial condition, including their capital resources and liquidity positions. The bank’s risk management framework should be comprehensive with respect to the (material) climate-related financial risks they are exposed to. Clear definitions and thresholds should be set for materiality. These need to be monitored closely and adjusted, if necessary, as climate-related risks are evolving.

Management monitoring and reporting – Principle 7

After ensuring that the risk framework is comprehensive, banks need to implement the monitoring and reporting of climate-related financial risks in a timely manner to facilitate effective decision-making. To achieve such reporting, a good data infrastructure should be in place at the bank. This allows it to identify, collect, cleanse, and centralize the data necessary to assess material climate-related financial risks. Furthermore, banks should actively collect additional data from clients and counterparties in order to develop a better understanding of their client’s transition strategies and risk profiles.

Management of credit, market, liquidity, operational risk – Principles 8 to 11

Banks should understand the impact of climate-related risk drivers on their credit risk profiles, market positions, liquidity risk profiles and operational risks. Clearly articulated credit policies and processes to identify, measure, evaluate, monitor, report and control or mitigate the impacts of material climate-related risk drivers on banks’ credit risk exposures should be in place. From a market risk perspective, banks should consider the potential losses in their portfolios due to climate-related risks. On the business operation and strategy side of banking activities, the impact of climate-related risks also plays a large role. For example, physical risks have to be taken into account when drafting business continuity plans. After understanding the different risks and their impacts, a range of risk mitigation options to control or mitigate climate-related financial risks need to be considered.

Scenario analysis – Principle 12

The final principle states that banks need to use scenario analysis to assess the resilience of their business models and strategies to a range of plausible climate-related pathways, and to determine the impact of climate-related risk drivers on their overall risk profile. Scenario analysis should reflect the overall relevant climate-related financial risks for banks, including both physical and transition risks. This analysis should be performed for different time horizons, both short- and long-term, and should be highly dynamic.

Changes to the BCBS risk framework draft and related publications

The final Principles have not changed much compared to the November 2021 consultation document. The most important changes are that the first principle, concerning corporate governance of banks, and the fifth principle, concerning capital and liquidity adequacy, have been extended. The corporate governance principle, for example, now also includes that banks should ensure that their internal strategies and risk appetite statements are consistent with any publicly communicated climate-related strategies and commitments. The capital and liquidity adequacy principle now includes a section requiring banks to incorporate material climate-related financial risks in their stress testing programs.

These twelve bank-focused principles, providing banks guidance on effective risk management of climate-related financial risks, can also be linked to the initiatives of other regulators such as the ECB. In November 2020, for example, the ECB provided a guide that describes how it expects institutions to consider climate-related and environmental risks, when formulating and implementing their business strategy, governance and risk management frameworks (the ECB expectations). These ECB expectations are in line with the BCBS Principles (and often more elaborate).

Zanders has gained relevant experience in implementing the ECB expectations at several Dutch banks. This experience ranges from risk identification and materiality assessments to the quantification of climate-related risks, ESG data frameworks, model validations, and scenario analysis. Please reach out to us if your bank is seeking support in implementing the BCBS Principles.

References
1) Basel Committee on Banking Supervision (2012). Core Principles for Effective Banking Supervision.
2) Basel Committee on Banking Supervision (2022). Principles for the effective management and supervision of climate-related financial risks.

In the below overview, we present an overview of the main ESG-related publications from the European Commission (EC), the European Central Bank (ECB), and the European Banking Authority (EBA).

This is complemented by the most important timelines that are stipulated in these regulations and guidelines. Additional regulations and guidelines that are expected for the next couple of years are also highlighted.

If you want to discuss any of them, don’t hesitate to reach out to our subject matter experts.

It is clear that the outline agreement 2018 (Hoofdlijnen Akkoord 2018) is starting to crack. Slowing down the growth of medical-specialist care expenses to zero percent has not yet proved feasible in practice. Demographic developments, among other things, are causing demand for care to rise, but the parties are unable to realize the intended transition from hospital care to primary care at the same pace. In the mean time, however, insurers want to stick to the zero percent goal while hospitals do not want to turn patients away. In some arrangements, particularly those involving “effective care”, care provided in excess of the agreed amount is still (partly) reimbursed.

NECESSARY INVESTMENTS

As for the hospitals, in addition to the increase in demand for care, more money is needed. The recent CAO agreements are not covered by the regular agreements with the health insurer. Furthermore, it is common knowledge that the level of investment has lagged behind in recent years. Hospitals cannot continue to postpone the necessary investments in renovation, electronic patient files and further automation. Room must be created in operations to be able to bear the extra financing costs (interest and depreciation) in the long run.

"The hospital’s business case, with a projection of new investments, can no longer be made on the basis of the outcome of the negotiations with the health insurer."

Delivering care for the right remuneration has therefore become an increasingly delicate balancing act. The question is how the hospital will succeed in doing this within its operations and continue to comply with its financing ratios. The transition does not result in any cuts. Savings must come from the application of new concepts that lead to greater efficiency and a lower demand for second-line care. However, these developments take place at a slower pace than desired. Until then, hospitals feel, health insurers should step in. At least, as mentioned above, by reimbursing “effective care” above the agreed amount. The alternative is to raise the rates where there is still some room. So P or Q.

FINANCIAL BUSINESS CASE

The hospital’s business case, with a projection of new investments, can no longer be made on the basis of the outcome of the negotiations with the health insurer. Instead, during the negotiation process the person who controls the multi-year budget model – the treasurer – must be involved in the process. This gives the hospital more insight into the financial consequences. Sharing these insights with the health insurer can better substantiate the hospital’s arguments and thus provide more insight during negotiations. This way, the insurer becomes more directly involved in the long-term prognosis and the long-term financial health of the hospital. It thereby becomes a joint objective to achieve affordable care in the long term.

An important part of the financial business case is shaped during negotiations with the insurer. During the negotiations, the hospital wants to be able to steer the long-term impact of the outcomes. This is the only way to ensure that a proposition emerges that is financeable for banks and secure for the WfZ (Guarantee Fund for the Health Care Sector), and that the hospital is able to comply with the financing ratios in the long term. It will remain a balancing act, but one with a more solid basis.

Financial setbacks can occur due to, for example, higher construction costs, inability to invoice due to IT problems, or production falling behind due to staff shortages. Savings, also called liquidity buffer, give you some time in such situations to take measures to resolve the incidents. If these temporary liquidity shortfalls cannot be compensated in time, this may translate into structural problems, deterioration of cash flow ratios, higher risk premiums on loans and, in the long term, perhaps even bankruptcy. A buffer therefore seems logical, but the design of a liquidity buffer is not that easy. After all, how is the amount and form of the buffer determined?

BUFFERING! (OR IS IT?)

Maintaining a liquidity buffer requires reserving available funds, but may be seen as unnecessary and socially undesirable. After all, there seems to be enough liquidity available to compensate setbacks and the public money could be better spent on social purposes. In practice, however, it happens that additional liquidity is not routinely or immediately available, or it is difficult to release funds quickly, or the additional liquidity is insufficient to temporarily compensate deficits.

Banks are also less likely to provide money to cover shortfalls during difficult times. In addition, the application process at a bank can take a relatively long time. To ensure the financial continuity of an institution in both good and bad times, many healthcare and educational institutions therefore feel the need to keep extra liquidity on hand, often encouraged by the accountant or the supervisory board. Next to that, bodies such as the WFZ (Guarantee Fund for the Health Care Sector), the Education Inspectorate and banks also stress the importance of a healthy liquidity buffer.

An important consideration is that the comfort of a liquidity buffer in the event of financial setbacks is only temporary. After all, you can only spend the money set aside once. If liquidity shortages continue and thus become structural in nature, you will have to look at long-term measures. However, using the liquidity buffer for structural deficits can give you more time to take a considered decision on the measures to be taken.

THE THICKER THE PIGGY BANK, THE BETTER?

An unequivocal answer to this question cannot be given. The starting points used differ per sector and per institution. In educational institutions, for example, we often see the current ratio as a yardstick for the buffer to be maintained. The current ratio indicates the relationship between the current assets and the current liabilities. The Education Inspectorate uses a current ratio of at least 0.5 for institutions in higher education and intermediate vocational education, and at least 0.75 for institutions in primary education, as a signaling value. However, many administrators and supervisory boards are comfortable with a higher standard and aim for a minimum ratio of 1.0 or higher.

An advantage of this methodology is that the current ratio does not yet take into account any room under the current account facility. This means that any current account facility can serve as an extra buffer in difficult times. A disadvantage is that the current ratio is generally a snapshot of the end of the year; no account is taken of intra-year developments. In case of an institution with volatile cash flows, guiding buffers by means of the current ratio can also lead to a yearly varying available buffer.

An alternative is to keep the amount of the liquidity buffer constant by steering towards an absolute norm. The WFZ, for example, advises healthcare institutions to use twice their turnover per month as the standard, but states that this is not a universal, objective standard. Zanders also sees many institutions using a standard of twice the monthly salary or 1.5 months' turnover. One point to note is that these standards are often quite high.

Our general advice is to gear the amount of the buffer to the liquidity development in both the short and long term, the risks and factors that play a role in your sector and in your institution. In addition, we recommend that the development of your long-term budget in the event of negative developments, also referred to as scenario analyses, be included in the consideration. Comfort can also play an important role. After all, it is up to you to determine which liquidity buffer is most appropriate and offers most comfort in daily operations.

DIFFERENT COMPONENTS OF YOUR BUFFER

Decisions must be made not only about the amount, but also about how to build up the liquidity buffer. Banks often offer the option of maintaining a liquidity buffer in the form of a current account facility, where the borrower pays commitment fees on the unused proportion and is charged a variable interest rate plus mark-up on the used portion. Generally, the amount of the current account is tailored to the institution's liquidity forecasts.

When deploying the current-account credit, it is important to determine whether it is committed or uncommitted. With an uncommitted overdraft, the bank can unilaterally cancel the facility daily - this is an availability risk. With a committed facility, there is the 'certainty' that the bank may not withdraw the facility during the agreed term. Also for this service, a commitment fee must be paid on the unused portion and the bank may ask for a higher mark-up during bad years when using the current account. In addition, there may be contractual terms that still allow the bank to unilaterally cancel the unused portion.

"An important consideration is that the comfort of a liquidity buffer in the event of financial setbacks is only temporary. After all, you can only spend the money set aside once."

From a risk perspective, it could therefore be argued that credit balances are safer than current account facilities. After all, this money cannot be cancelled unilaterally and there is no commitment fee on the unused portion or interest charges on the used portion. However, due to the low interest rates in recent years, the savings interest rate on credit balances has fallen to such a low level that it is currently even negative. For some banks this means that interest is no longer received on positive balances, but that from a certain size of credit balance onward, interest may have to be paid, also called negative interest. As a result, financing must then also be attracted in order to maintain the liquidity buffer, so there are double costs. In this case you not only pay interest on the credit balance, but also the regular financing costs.

Some institutions see their investment portfolio as an emergency pool they can use in difficult times. The advantage of invested money is that you do not suffer from negative interest rates or commitment fees. You also have a monthly stream of investment income. However, not every institution is allowed to invest money due to laws and regulations. Furthermore, you have to deal with counterparty risk, price risk in case of interim sales, and risk of negative returns. Moreover, the question is whether you can liquidate your investments fast enough to make payments.
The above options provide institutions with the room to have additional funds available during financially challenging times. However, the question remains as to which is the best option. Each option has advantages and disadvantages, and to make the choice even more difficult, a combination of the above options could also be a good solution for you.

CUSTOMIZATION, CUSTOMIZATION, CUSTOMIZATION...

Many institutions see the need to maintain a liquidity buffer either from a risk perspective, because of regulatory requirements, or for having comfort in operational execution. However, there is no simple answer to what the optimum level of a liquidity buffer is and how exactly it should be built. Each institution has its own risks and factors that must be taken into account. Setting up a liquidity buffer therefore requires a thorough analysis of cash flow development in the short and long term, key figures, costs, risks and options available from banks while adhering to legislation and regulations. In short, setting up a liquidity buffer is and remains custom work!

When a positive operating cash flow is realized, it is easier for a company to invest in acquisitions, fixed assets and innovation, for example. On the other hand, a negative operating cash flow can be an indication that the survival of an organization in the long term may be at risk. Therefore, a reliable cash flow forecast is of strategic importance for every organization and deserves attention at board level as well.
In one of our other articles about cash flow forecasting, we focus on information, processes and systems that are needed to come to an accurate cash flow forecast. In this article, we focus on the strategic side; which stakeholders, agreements and steering possibilities play a role to keep a grip on the cash flows in the long run?

STAKEHOLDERS

Having sufficient liquidity in the long run ultimately means continuity for the company. Internally, not only management (Board of Directors) but also the Supervisory Board (SB) is responsible for this. Large investments often have to be approved by both. They will therefore want to be informed well and in time about the expected development of the liquidity position in the short and longer term. After all, if a cash shortage threatens, directors' liability comes into play. The management board may not enter into any new obligations if it can reasonably assume that the current creditors cannot be paid (in the short term).
In some cases there may be a public shareholder. For them, insight into cash flows and the development of liquid assets is of great importance. After all, if a cash shortage is imminent, the shareholder is often the first to be approached to supplement this.
A company also has to deal with external stakeholders. The most important are often the financiers and the auditor. Financiers can be banks, but also ministries (through treasury banking) or care offices (funding). The financiers usually monitor the financial health of the company using various ratios and covenants. The liquidity position is very relevant here because, among other things, it gives an indication of the extent to which the organization is able to repay the outstanding loan(s).
Finally, the auditing external accountant follows the liquidity position with above-average interest, because when auditing the financial statements he must issue a continuity statement, among other things. This is only possible if there are sufficient liquid assets to meet current liabilities for at least 18 months in advance.

APPOINTMENTS

Internal agreements focus mainly on the frequency, timing and type of cash flow forecast. In calm, predictable times with an ample liquidity buffer the demands are different from those in uncertain, turbulent times. This therefore requires a different set-up of the organization. During predictable times and when there are no major investment plans, a good understanding of the liquidity position is still important, because it affects the amount of funding to be raised or the deployment of funds, for example.
However, in that case the frequency of forecasting does not have to be weekly, the timing is less strict and the indirect method suffices (in which the cash flows originate from the P&L account and the balance sheet. This method therefore also includes the cash effects of balance sheet changes). Reporting to management board members also takes place less frequently. However, if the company is in dire straits, this will not be sufficient and the frequency of the forecast and the reports will have to be increased. Moreover, the time horizon will be longer.

"In addition to making arrangements to make cash flows transparent, it is equally important to know what tools a director has to prevent a cash shortage."

The ability to attract additional funding is largely determined by the extent to which the organization is able to provide the necessary insight into, and correct substantiation of, the cash flows, assuming sufficient repayment capacity. This means that extra attention must be paid to the design of the processes, the mutual communication and the quality of the available data. Although these are matters that must be arranged in the operational process, this often does not happen automatically. It is therefore desirable for directors to keep a close eye and at least discuss the progress made in this area with the responsible manager(s).
It is also good for directors to be aware of the most important agreements in the financing contracts. For example: when must the (un)audited annual figures or the calculation of the bank covenants be submitted; what are the consequences of breaching the covenants; what conditions apply to obtaining a waiver? Although there is a whole process involved, it is good to realize that, worst case, failure to meet certain obligations in the contract can lead to an event of default and ultimately even a loan falling due.

CONTROL OPTIONS

In addition to making agreements to provide insight into cash flows, it is at least as important to know which instruments a director has to prevent a shortage of liquid assets. Before discussing this with financiers or possible shareholders, experience shows that they will often first demand that costs and revenues be closely scrutinized. Furthermore, outside the organization additional financing can be sought from banks or a ministry.
If available, a shareholder can be asked for additional capital. Which one should be approached first, again depends on the situation. In times of uncertainty, or when the financiers have financed a large amount (this can be determined using the net debt/EBITDA or Loan to Value), it is common to approach the potential shareholders first.
After all, because of the uncertainty about the future or the size of their current exposure, financiers will be reluctant to put extra money into the company. It is important to inform shareholders during good times and to keep them informed in the regular reporting cycle. To avoid being taken by surprise, they should be informed immediately of any development that could have a major impact. If the company is doing well and investments are needed to facilitate growth, for example, the financiers can be consulted first. Whether they are prepared to provide additional financing depends on several factors (such as the nature of the investment plans and the robustness of the forecasts provided), but the basic attitude will often be positive.

CONCLUSION

The importance of understanding the development of cash flows is not purely an operational matter. Cash flows play an important role in the continuity and flexibility of the business, the ability to invest, the timely identification of risks and the determination of the value of the business. For these reasons cash flows deserve attention at board level. To obtain good insights, the relationship with internal and external stakeholders, the agreements made with financiers and the measures to adjust play an important role. In all these matters, timeliness, predictability and accuracy are key to continuity and therefore important for a director. It is advisable to continuously invest in and pay attention to these issues.