What's the colour of money?

‘Familiarity breeds contempt’ is a line from Hollywood Beyond’s hit single, ‘What’s the colour of money?’. The same phrase could arguably be used to describe bankers’ relationship with money in the run up to the recent credit crunch. Although managing liquidity is, and has always been, an important activity for banks, many neglected to give it the attention it deserves. The recent financial crisis has, however, changed all of that.

The economic downturn has served not only to confirm the need for effective liquidity management, but also – and crucially - to highlight shortfalls in the current methods used. Liquidity management is entering a new era and it’s clear that banks need to learn the lessons from the past 18 months and take a different approach to this important banking activity.

While the basics of liquidity management have not changed, liquidity management practices need to change in two principal ways: firstly, banks need to manage liquidity on an intra-day basis (as opposed to a daily basis); and secondly, banks need to be able to manage multiple liquidity positions.

Sound liquidity management today involves tracking payments and exposure on a minute-by-minute basis, and managing liquidity to an intra-day, real-time position, while still forecasting end-of-day and collateral positions. Banks must have the ability to track and manage collateral to create liquidity, link collateral to cash, and earmark the collateral as appropriate. And finally, they need to control the release of payments based on actual and projected balances, ensuring that liquidity is optimised in order that costs are controlled.

The advent of pan-European systems in the wake of the euro has built links between systems across the Eurozone. The interaction between clearing and settlement mechanisms has become more prevalent, as the blurring of the distinction between RTGS and Automated Clearing House takes hold. Many of the liquidity concerns restricted traditionally to the realm of RTGS are now beginning to be felt in ACH and ‘retail’ clearing and settlement systems. Today, liquidity management is required across a much greater range of payment processes.

Perhaps the biggest change however is recognising that banks’ own liquidity management is no longer an issue just for them and their customers, but one for the greater world community of which they are a part. The ripples from liquidity mismanagement in one institution can spread all too rapidly in the global banking community. With the regulators hot on their heels, banks are also themselves realising that liquidity management, and the ability to manage liquidity on an intra-day basis, has become a significant competitive advantage and one that can signal success or demise for a bank.