Are climate change risks properly captured in the prudential framework?
In March 2021, the European Banking Authority (EBA) was mandated through Article 501c of the Capital Requirements Regulation (CRR) to “assess […] whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified”.
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.
After briefly presenting the DP, this article reviews the current Pillar 1 Capital (P1C) requirements. We limit ourselves to the P1C requirements for credit risk as this is by far the largest risk type for banks. Furthermore, we only discuss the interaction of the P1C with climate change risks (as opposed to broader environmental and/or social risk types). After establishing the extent to which the prudential framework takes climate change risks into account, possible amendments to the framework will be considered.
Key take-aways of this article:
- The current prudential framework includes several mechanisms that allow the reflection of climate change risks into the P1C.
- The interaction between P1C and climate change risks is limited to specific parts of the portfolio, and in those cases, it remains to be seen to what extent this is properly accounted for at the moment.
- Amendments to the prudential framework can be considered, but it is important to avoid double counting issues and to take into account differences in time horizons.
- The EBA is expected to publish a final report on the prudential treatment of environmental risks in the first half of this year.
- Financial institutions that are using the internal ratings-based approach are advised to start with the incorporation of climate change risks into PD and LGD models.
EBA’s Discussion Paper
In the introduction of the DP, the EBA mentions the increasing environmental risks – and their interaction with the traditional risk types – as the trigger for the review of the prudential framework. One of the main concerns is whether the current framework is sufficiently capturing the impact of transition risks and the more frequent and severe physical risks expected in the coming decades. In this context, they stress the special characteristics of environmental risks: compared to the traditional risk types, environmental risks tend to have a “multidimensional, non-linear, uncertain and forward-looking nature.”
The EBA also explains that the P1C requirements are not intended to cover all risks a financial institution is exposed to. The P1C represents a baseline capital requirement that is complemented by the Pillar 2 Capital requirement, which is more reflective of a financial institution’s specific business model and risks. Still, it is warranted to assess whether environmental risks are appropriately reflected in the P1C requirements, especially if these lead to systemic risks.
Even though the DP raises more questions than it provides answers, some starting points for the discussion are introduced. One is that the EBA takes a risk-based approach. Their standpoint is that changes to the prudential framework should reflect actual risk differentials compared to other risk types and that it should not be a tool to (unjustly) incentivize the transition to a sustainable economy. The latter lies “in the remit of political authorities.”
The DP also discusses some challenges related to environmental risks. One example is the lack of high-quality, granular historical data, which is needed to support the calibration of the prudential framework. The EBA also mentions the mismatch in the time horizon for the prudential framework (i.e., a business cycle) and the time horizon over which the environmental risks will unfold (i.e., several decades). They wonder whether “the business cycle concepts and assumptions that are used in estimating risk weights and capital requirements are sufficient to capture the emergence of these risks.”
Finally, the EBA does not favor supporting and/or penalizing factors, i.e., the introduction of adjustments to the existing risk weights based on a (green) taxonomy-based classification of the exposures1. They are right to argue that there is no direct relationship between an exposure’s sustainability profile and its credit risk. In addition, there is a risk of double counting if environmental risk drivers have already been reflected in the current prudential framework. Consequently, the EBA concludes that targeted amendments to the framework may be more appropriate. An example would be to ensure that environmental risks are properly included in external credit ratings and the credit risk models of financial institutions. We explain this in more detail in the following paragraphs.
Pillar 1 Capital requirements
The assessment to what extent climate change risks are properly captured in the current prudential framework requires at least a high-level understanding of the framework. Figure 1 presents a schematic overview of the P1C requirements.
The P1C (at the top of Figure 1) depends on the total amount of Risk-Weighted Assets (RWAs; on the row below)2. RWAs are determined separately for each (traditional) risk type. As mentioned, we only focus on credit risk in this article. The RWAs for credit risk are approximately 80% of the average bank’s total RWAs3. Financial institutions can choose between two methodologies for determining their credit risk RWAs: the Standardized Approach (SA)4 and the internal ratings-based (IRB) approach5 . In Europe, on average 40% of the total RWAs for credit risk are based on the SA, while the rest is based on the IRB approach6 :
Figure 1 – Schematic overview of the P1C requirements and the interaction with climate change risks
Standardized Approach
In the SA, risk weights (RWs) are assigned to individual exposures, depending on their exposure class. About 50% of the RWAs for credit risk in the SA stem from the Corporates exposure class7. Generally speaking, there are three possible RW drivers: the RWAs depend on the external credit rating for the exposure, a fixed RW applies, or the RW depends on the Loan-to-Value8 (LtV) of the (real estate) exposure. The RW for an exposure to a sovereign bond for example, is either equal to 100% if no external credit rating is available (a fixed RW) or it ranges between 0% (for an AAA to AA-rated bond) and 150% (for a below B-rated bond).
Internal Ratings-Based Approach
Within the IRB approach, a distinction is made between Foundation IRB (F-IRB) and Advanced IRB (A-IRB). In both cases, a financial institution is allowed to use its internal models to determine the Probability of Default (PD) for the exposure. In the A-IRB approach, the financial institution in addition is allowed to use internal models to determine the Loss Given Default (LGD), Exposure at Default (EAD), and the Effective Maturity (M).
Interaction with climate change risks
The overview of the P1C requirements introduced in the previous section allows us to investigate the interaction between climate change risks and the P1C requirement. This is done separately for the SA and the IRB approach.
Standardized Approach
In the SA, there are two elements that allow for interaction between climate change risks and the resulting P1C. Climate change risks could be reflected in the P1C if the RW depends on an external credit rating, and this rating in turn properly accounts for climate change risks in the assessment of the counterparty’s creditworthiness (see 1 in Figure 1). The same holds if the RW depends on the LtV and in turn, the collateral valuation properly accounts for climate change risks (see 2 in Figure 1). This raises several concerns:
First, it can be questioned whether external credit ratings are properly capturing all climate change risks. In a report from the Network for Greening the Financial System (NGFS) [3], which was published at the same time as EBA’s DP, it is stated that credit rating agencies (CRAs) have so far not attempted to determine the credit impact of environmental risk factors (through back-testing for example). Also, the lack of high-quality historical data is mentioned as an explanation that statistical relationships between environmental risks and credit ratings have not been quantified. Further, a paper published by the ECB [4] concludes that, given the current level of disclosures, it is impossible for users of credit ratings to establish the magnitude of adjustments to the credit rating stemming from ESG-related risks. Nevertheless, they state that credit rating agencies “have made significant progress with their disclosures and methodologies around ESG in recent years.” The need for this is supported by academic research. An example is a study [5] from 2021 in which a correlation between credit default swap (CDS) spreads and ESG performance was demonstrated, and a study from 2020 [6] which demonstrated that high emitting companies have a shorter distance-to-default.
Secondly, the EBA has reported in the DP that less than 10% of the SA’s total RWAs is derived based on external credit ratings. This implies that a large share of the total RWAs is assigned a fixed RW. Obviously, in those cases there is no link between the P1C and the climate change risks involved in those exposures.
Finally, climate change risks only impact the P1C maintained for real estate exposures to the extent that these risks have been reflected in collateral valuations. Although climate change risks are priced in financial markets according to academic literature, many papers and institutions indicate that these risks are not (yet) fully reflected. In a survey held by Stroebel and Wurgler in 2021 [7], it is shown that a large majority of the respondents (consisting of finance academics, professionals and public sector regulators, among others) is of the opinion that climate change risks have insufficiently been priced in financial markets. A nice overview of this and related literature is presented in a publication from the Bank for International Settlements (BIS) [8]. The EBA DP itself lists some research papers in chapter 5.1 that indicate a relationship between a home’s sales price and its energy efficiency, or with the occurrence of physical risk events. It is unclear though if climate change risks are fully captured in the collateral valuations. For example, research is presented that information on flood risk is not priced into residential property prices. Recent research by ABN AMRO [9] also shows this.
Internal Ratings-Based Approach
In the IRB approach, financial institutions have more flexibility to include climate change risks in their internal models (see 3 in Figure 1). In the F-IRB approach this is limited to PD models, but in the A-IRB approach also LGD models can be adjusted.
A complicating factor is the forward-looking nature of climate change risks. In recent years, the competent authorities have pressured financial institutions to use historical data as much as possible in their model calibration and to back-test the performance of their models. As climate change risks will unfold over the next couple of decades, these are not (yet) reflected in historical data. To incorporate climate change risk, expert judgement would therefore be required. This has been discouraged over the past years (e.g., through the ECB’s Targeted Review of Internal Models (TRIM)) and it will probably trigger a discussion with the competent authorities. A possible deterioration of model performance (due to higher estimated risks compared to historically observations) is just one example that may attract attention.
Another complicating factor is that under the IRB approach, the PD of an obligor is estimated based on long-run average one-year default rates. While this may be an appropriate approach if there are no clear indications that the overall risk level will change, this does not hold if climate change risks increase in the future, and possibly increase systemic risks. By continuing to base a PD model on historical data only, especially for exposures with a time to maturity beyond a couple of years, the credit risk may be understated.
Are amendments to the prudential framework needed?
We have explained that there are several mechanisms in the prudential framework that allow environmental risks to be included in the P1C: the use of external credit ratings, the valuation of collateral, and the PD and LGD models used in the IRB approach. We have also seen, however, that it is questionable whether these mechanisms are fully effective. External credit ratings may not properly reflect all environmental risks and these risks may not be fully priced in on capital markets, leading to incorrect collateral values. Finally, a large share of the RWAs for credit risk depends on fixed RWs that are not (environmentally) risk-sensitive.
Consequently, it can be argued that amendments or enhancements to the prudential framework are needed. One must be careful, however, as the risk of double counting is just around the corner. Therefore, the following amendments or actions should be considered:
- Further research should be undertaken to investigate the relationship between climate change risk and the creditworthiness of counterparties. If there is more clarity on this relationship, it should also be assessed to what extent this relationship is sufficiently reflected in external ratings. Requiring more advanced disclosures from credit rating agencies could help to understand whether these risks are sufficiently captured in the prudential framework. One should be cautious to amend the ratings-based RWs in the SA, since credit rating agencies are continuously working on the inclusion of environmental risks into their credit assessments; there would be a real risk of double counting.
- The potential negative impact of climate change risks on collateral value should be further investigated. Financial institutions are already required by the ECB9 to consider environmental risks in their collateral valuations but this is not at a sufficient level yet. It will be important to consider the possibility of sudden value changes due to transition risks like shifting consumer sentiment or awareness.
- To improve the risk-sensitivity of the framework, a dependency on the carbon emissions of the counterparty could be introduced in the fixed RWs, possibly only for the most carbon-intensive sectors. It could be argued that there are other factors that have a more significant relationship with the default risk of a certain counterparty that could be included in the SA. Climate change risks, however, differ in the sense that they can lead to a systemic risk (as opposed to an idiosyncratic risk) that is currently not captured in the overall level of the RWs.
- In the SA, a distinction could be introduced based on the exposure’s time to maturity. For relatively short-term exposures, the current calibrations are probably fine. For longer-term exposures, however, the risks stemming from climate change may be underestimated as these are expected to increase over time.
- In the IRB approach, a reflection of climate change risk would require the regulator to allow for forward-looking expert judgment in the (re)calibration of PD and LGD models. Further guidance from the competent authorities on the potentially negative impact on model performance based on historical data would also be useful.
Conclusion
Based on the schematic overview of the P1C requirements and the (potential) interaction with climate change risks, we conclude that several mechanisms in the prudential framework allow for climate change risks to be incorporated into the P1C. At the same time, we conclude that this interaction is limited to specific parts of the portfolio, and that in those cases it remains to be seen to what extent this is properly accounted for. To remedy this, amendments to the prudential framework could be considered. It is important, however, to avoid double counting issues and to be mindful of time horizon differences.
It is expected that the EBA will publish a final report on the prudential treatment of environmental risks in the first half of this year. However, especially financial institutions that are using the IRB approach should not take a wait-and-see approach. Given the complexity of modeling climate change risks, it is prudent to start incorporating climate change risks into PD and LGD models sooner rather than later.
With Zanders’ extensive experience covering both credit risk modeling and climate change risk, we are well suited to support with this process. If you are looking for support, please reach out to us.
1 Supporting factors are currently in place for SMEs and infrastructure projects, but the EBA advocated their removal.
2 See RBC20.1 in the Basel Framework.
3 See for example the results from the EBA’s EU-wide transparency exercise. This is reflected in Figure 1 by the percentage in the grey link between P1C and RWAs for credit risk.
4 See CRE20 to CRE22 in the Basel Framework.
5 See CRE30 to CRE36 in the Basel Framework.
6 In the Netherlands, less than 20% of the total RWAs is based on the SA. See the EBA’s EU-wide transparency exercise for more information. The percentages in the grey link between ‘Risk-weighted assets’ and ‘Methodology’ in Figure 1 are based on the European average.
7 See the EBA’s Risk assessment of the European banking system [2]. The percentages in the grey link between ‘Standardized Approach’ and the ‘Exposure class’ in Figure 1 reflect the share of RWAs in the SA for each of the different exposure classes.
8 The LtV is defined as the ratio between the loan amount and the value of the property that serves as collateral.
9 See expectation 8.3 in the ECB’s Guide on climate-related and environmental risks.
References
- The role of environmental risks in the prudential framework, European Banking Authority, Discussion Paper, 2 May 2022
- Risk assessment of the European banking system, European Banking Authority, December 2022
- Capturing risk differentials from climate-related risks, Network for Greening the Financial System, Progress Report, May 2022
- Disclosure of climate change risk in credit ratings, European Central Bank, Occasional Paper Series, No. 303, September 2022
- Pricing ESG risk in credit markets, Federated Hermes, March 2021
- Climate change and credit risk, Capasso, Gianfrate, and Spinelli, Journal of Cleaner Production, Volume 266, September 2020
- What do you think about climate finance?, Stroebel and Wurgler, Journal of Financial Economics, vol 142, no 2, November 2021
- Pricing of climate risks in financial markets, Bank for International Settlements, Monetary and Economic Department, December 2022
- Is flood risk already affecting house prices?, ABN AMRO, 11 February 2022
- Guide on climate-related and environmental risks, European Central Bank, November 2020
BCBS Principles for the effective management of climate-related financial risks
In March 2021, the European Banking Authority (EBA) was mandated through Article 501c of the Capital Requirements Regulation (CRR) to “assess […] whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified”.
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.
Regulatory timelines ESG Risk Management
In March 2021, the European Banking Authority (EBA) was mandated through Article 501c of the Capital Requirements Regulation (CRR) to “assess […] whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified”.
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.
The balancing act between hospital and health insurer
At the beginning of January 2020, various media reported that the negotiations between health insurers and hospitals were proceeding with difficulty and were therefore not yet completed. For a number of years this went reasonably well, but due to conflicting interests this problem has returned.
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.
Liquidity buffer: a matter of customized solutions
The financial health of public institutions has been in the spotlight more prominently since the financial crisis. A healthy institution can meet its financial obligations in both the short and long term. This is reflected in good ratio developments, such as solvency, Loan-to-Value (LtV) and the Debt Service Coverage Ratio (DSCR). However, having healthy ratios does not automatically mean that you will have sufficient funds available quickly in case of incidental financial setbacks.
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!
Getting a grip on the cash strategy
Monitoring the development of liquidity might be regarded as a purely operational matter in your organization too. But if you look further, you will realize that liquidity has an important strategic component and is a good performance indicator.
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.
Update of liquidity forecasts
Within an organization, important choices are made based on the current and expected liquidity position. It is therefore of great importance that the liquidity position is accurately portrayed and regularly updated.
During uncertain times, making a forecast requires extra effort and poses a greater challenge. For example, due to uncertainty, it may be decided to update the liquidity forecast(s) more frequently. The question raised then is what frequency is appropriate and how to deal with the assumptions underlying forecasts made during an economically sound period. In this article we discuss the information, processes and systems that are important for getting (and keeping) a good grip on the development of cash flows. Ultimately, as an organization you want to have a reliable picture at all times of the expected development of the liquidity in the short, medium and long term.
AVAILABILITY OF THE RIGHT INFORMATION
In order to obtain the best possible picture of the liquidity position, the quality of the underlying information is of great importance. The realized and projected profit and loss account, balance sheet, investment plans and transactions form an important part of the input. From a theoretical point of view, there are two methods to translate this input into the calculation of the (expected) cash flows; the direct and the indirect method.
- Under the direct method, cash flows are based on individual incoming and outgoing transactions, such as accounts receivable receipts, accounts payable payments, investments and interest payments.
- Cash flows under the indirect method arise from the P&L account and the balance sheet. Thus, under this method, the cash effects of balance sheet changes are also included.
Which method is appropriate depends in part on the length of the specific forecast. Actual bank movements (or an accurate estimate of these), on which the direct method is based, are often available for a relatively short period of time. This makes this method suitable for a short-term forecast. With the indirect method, the cash flows are derived from the projected P&L account and balance sheet. Because of this combination, this method is ideal for medium and long-term forecasts.
The most appropriate methodology depends partly on the length of the liquidity forecasts. In order to obtain a good picture of the liquidity position in the short, medium and long term, various forecasts must be prepared. These forecasts differ in terms of time units (week, month, quarter and year) and length (quarter, year and > 1 year). The matrix below shows the different time lines again, with the different forecasts shown vertically. To the right of the matrix, the appropriate methods for each forecast are shown.
Here, it is often the case that the longer the period over which the forecast is made, the less accurate the forecast. The choices regarding time units and length of the forecast are related to the phase in which the organization finds itself and the type of sector in which the organization operates. For example, in times of economic uncertainty (such as the current pandemic) or in the case of a weak financial position, it is often chosen - sometimes imposed by external financial stakeholders (e.g. special management of a bank) - to produce a short term forecast on a weekly basis. This should ensure that the financial position is brought into focus on a weekly basis, thereby increasing the grip on cash flows.
"In order to get a good picture of the liquidity position in the short, medium and long term, various forecasts need to be made."
However, this does not mean that the financial position is more accurately portrayed by creating more forecasts of different lengths. Indeed, too many (different) forecasts generate a constant time investment that is too great to keep updating them.
When an organization is in a "quiet" period, a monthly forecast for 12 months rolling, combined with a multi-year (annual) forecast for 5 years rolling, may be sufficient. However, consistency between forecasts is crucial. The inputs provided should be consistent across the different forecasts, and the time units of the different forecasts should overlap. For example, if a 13-week forecast (quarterly) is chosen, it will logically align with the liquidity forecast of at least 12 months rolling on a quarterly basis.
EMBEDDING IN SYSTEMS
One of the tools needed to process and update all information is a system that brings together all cash flow information. In practice, a treasury module in the existing ERP system or an Excel file is regularly used. If Excel is used without a clear format, it often turns out to be too complex, confusing and prone to errors. With a clear format, Excel can certainly be a suitable tool. In addition, one can choose to largely automate the forecasting process by means of an application.
The format of the chosen system will act as a means of creating consensus among internal stakeholders on the approach and principles of forecasting. In addition, it will create clarity towards external stakeholders. In order to maintain an overview, it is advisable to subdivide the cash flows into a limited number of items. The following three types of cash flows provide the basis for this:
- Operating cash flow: all cash flows resulting from operations.
- Investing cash flow: consisting of the investments in fixed assets, investments in the form of acquisitions or revenue sales.
- Financing cash flow: all expenditures and income from financing activities (a different choice can be made with respect to interest).
TREASURYnxt provides organizations with a flexible way to create liquidity forecasts for the above cash flows. To learn more about TREASURYnxt , click here.
GETTING A GRIP ON CASH THROUGH THE RIGHT PROCESSES
Besides information and systems, processes will need to be established within the organization to really get a grip on the cash position. Fixed processes bring structure to the preparation, comparison and updating of forecasts. It must always be possible to answer the question of why a particular cash flow differs from a previously prepared forecast.
It is important to be able to explain the difference between two liquidity forecasts of different times. A clear format can help with this. The challenge lies in constantly updating and reconciling these forecasts. If, for example, an investment is postponed, this will have to be reflected immediately in the investment cash flows of the forecasts. Here, clear communication is crucial. This starts with internal communication, by means of regular meetings or calls (so-called cash calls). By scheduling regular cash calls, during which the cash position and expectations are discussed and analyzed, the forecasts remain up-to-date. It is preferable to align the frequency of these cash calls with the frequency of the relevant forecast. In communications with external stakeholders, it is particularly important to provide insight into the risks and opportunities of the forecasts that have been prepared.
Finally, it is essential to compare the actual realization of the cash flows with the forecast that was prepared for the cash flows. The deviations and insights arising from this must be taken into account in the forecast for the subsequent period. After processing this realization, the length of the relevant forecast will have to remain unchanged, a so-called rolling forecast.
Ultimately, grip on the cash position can only be realized through the combination of information, systems and processes. A clear vision on this helps to structure this interplay.
Savings modelling series: The impact of savings rate floors on balance sheet management
Low interest rates, decreasing margins and regulatory pressure: banks are faced with a variety of challenges regarding non-maturing deposits. Accurate and robust models for non-maturing deposits are more important than ever. These complex models depend largely on a number of modelling choices. In the savings modelling series, Zanders lays out the main modelling choices, based on our experience at a variety of Tier 1, 2 and 3 banks.
The low or even negative market rates in many Western European countries significantly affect banks’ pricing and funding strategy. Many banks hesitate to offer negative rates on non-maturing deposits (NMD) to retail customers. In some markets, like in Belgium, regulatory restrictions impose a lower limit on the savings rate that a bank can offer. The adverse impact of these developments is that current funding margins for many banks are under pressure.
The flooring effect on variable rate deposits is a hot topic for banks’ Risk Management functions due to its impact on the pricing dynamics and customer behaviour. Although it is possible that banks offer negative deposit rates when interest rates continue to decrease (“soft flooring”), banks depend on the pricing strategy of competing banks. Next to that, offering negative rates can cause serious reputational damage, leading to deposit volume outflows. The next paragraphs outline the key focus regarding risk reporting, economic hedges, and risk models for Risk and ALM managers.
BREACHING THE SUPERVISORY OUTLIER TEST
Banks are likely to hit the Supervisory Outlier Test (SOT) because of the asymmetric sensitivity of the economic value to interest rate shocks. Banks must inform their supervisor when the Economic Value of Equity change resulting from specific interest rate scenarios exceeds certain thresholds. Asymmetric pricing effects on NMD can have substantial impact on economic value and earnings. This is because when NMD rates are close to the floor, the interest rate sensitivity decreases. This effectively makes NMD similar to fixed-rate instruments like bonds.
"Banks are likely to hit the Supervisory Outlier Test (SOT) because of the asymmetric sensitivity of the economic value to interest rate shocks."
Risk Management functions need to adjust the Economic hedge to mitigate the interest rate typical gap between assets and liabilities. While NMD are traditionally variable-rate products, these behave more like interest rate insensitive instruments in a low interest environment. Risk managers need to reflect this impact in the economic hedge. It is important to realize that it is difficult to capture the non-linearity of NMD, resulting from the floor, with linear financial instruments such as interest rate swaps. Although some banks are adjusting the hedge on a best-estimate (duration or DV01) basis, the asymmetric pricing effects will largely be left unhedged. Banks can choose to accept and monitor this risk, or capitalize for it.
Risk models need to be adjusted to reflect flooring effects on NMD. For most Western European markets, historical data is dominated by higher interest rate levels and does not yield representative behavioural risk estimations.
SAVINGS MODELLING SERIES
This short article is part of the Savings Modelling Series, a series of articles covering five hot topics in NMD for banking risk management. The other articles in this series are:
Savings modelling series – How ‘hidden savings’ impact the risk profile for banks
Low interest rates, decreasing margins and regulatory pressure: banks are faced with a variety of challenges regarding non-maturing deposits. Accurate and robust models for non-maturing deposits are more important than ever. These complex models depend largely on a number of modelling choices. In the savings modelling series, Zanders lays out the main modelling choices, based on our experience at a variety of Tier 1, 2 and 3 banks.
WHAT ARE HIDDEN SAVINGS?
Because the low or zero rates offered by banks provide little motivation to move money to savings accounts, many banking customers use their current accounts as savings account. It is very likely that customers will move part of this money to savings accounts when rates increase again. This ‘hidden savings’ or ‘savings substitution’ volume and savings accounts volume have the same interest rate sensitivity, including the asymmetric ‘flooring’ effect.
SO, HOW DO I DEAL WITH THEM?
Given the existence of these hidden savings, it might be justified to model it with a shorter maturity, thereby increasing funding stability. Because hidden savings proves to be very difficult to quantify and substantiate in practice, its modeling is still not general practice with Risk and ALM managers. The banks that do include the hidden savings effect typically use historical data-based approaches, combined with expert-based guidelines on the measurement approach and significance thresholds. Significance thresholds can be relative (a fixed percentage of total current accounts volume) or absolute amounts (for example 100 million euro of volume).
"Because the low or zero rates offered by banks provide little motivation to move money to savings accounts, many banking customers use their current accounts as savings account."
USING HISTORICAL DATA
Some banks use historical portfolio data to estimate the hidden savings portion of current accounts. Hidden savings is defined as the portion of volume after subtracting the volatile and long-term volume. The volatile (non-stable) volume is estimated based on intra-month (daily) volume fluctuations. The long-term, non-repricing, volume (core volume) can be estimated based on historical minimum volume levels.
Another measurement approach is to use account-level data to estimate the hidden savings volume. The average current account balance development over time is used to identify a trend of accelerating balance levels. Hidden savings is derived as the portion of current account volume above historically identified trends. To identify these historical trends, sufficient historical data on time periods with a significant difference between savings and current accounts rates are required.
SAVINGS MODELLING SERIES
This short article is part of the Savings Modelling Series, a series of articles covering five hot topics in NMD for banking risk management. The other articles in this series are:
Savings modelling series: Non-maturing deposits model concepts
Low interest rates, decreasing margins and regulatory pressure: banks are faced with a variety of challenges regarding non-maturing deposits. Accurate and robust models for non-maturing deposits are more important than ever. These complex models depend largely on a number of modelling choices. In the savings modelling series, Zanders lays out the main modelling choices, based on our experience at a variety of Tier 1, 2 and 3 banks.
Are you interested in a more in-depth comparison of deposit modeling concepts? Click here.
For banks with significant non-maturing deposits portfolios, Risk Management functions need to have a robust behavioural risk model. This model is required for Interest Rate Risk in the Banking Book reporting, hedge, stress testing, risk transfer, and ad-hoc analyses. Although specific modelling assumptions vary per bank, cashflow-based models, a replicating portfolio model, or a hybrid model are market practice model concepts. The choice for one of these models is strongly linked to model purpose and use. Each concept has its benefits and drawbacks for different purposes and uses.
CASHFLOW-BASED MODELS
Cashflow-based models consist of two sub-models for the deposit rate and volume that forecast coupon and notional cashflows, respectively. Both sub-models measure the relationship between behavioural risk and underlying explanatory factors. Cashflow-based models are suited to include asymmetric pricing effects (such as flooring of rates) in resulting risk metrics. Since the approach captures rate and volume dynamics well, it is also often used for ad-hoc behavioural risk analysis and stress testing.
"The choice for one of these models is strongly linked to model purpose and use."
REPLICATING PORTFOLIO MODELS
Replicating Portfolio models replicate a deposit portfolio into simple financial instruments (e.g., bonds) such that its risk profile matches the risk profile of the underlying deposits. The advantage is that it converts a complex product into tangible financial instruments with a coupon and maturity. This simplified portfolio is well-suited to transfer risk from business units to treasury departments. A disadvantage of the model is that it does not fully capture non-linear deposit behaviour, for example the asymmetric pricing effects resulting from the floor. This makes the approach less suited for stress testing or ad-hoc behavioural risk analysis for senior management.
Read our extensive analysis of replicating portfolio models here.
HYBRID MODELS
Hybrid models, consisting of both a cash flow model and replicating portfolio model, combine the benefits of the other approaches, but at the cost of increased complexity. These models are often used by banks that want to use the model for a wide range of purposes: risk transfer to treasury departments, risk reporting, ad-hoc behavioural risk analysis, and stress testing. To prevent a larger mismatch between the models, most banks ensure that the risk profiles (duration or DV01) of both models align.
SAVINGS MODELLING SERIES
This short article is part of the Savings Modelling Series, a series of articles covering five hot topics in NMD for banking risk management. The other articles in this series are:
