Effective Liquidity Management in the Post-Credit-Crunch Era
The topic of effective liquidity management in the post-credit-crunch era is especially interesting when viewed under the general umbrella of asset liability management for financial institutions. The latter comprising, amongst many, banks, life insurance companies, pension funds, etcetera, to name but a few. But, what is meant by this post-credit-crunch-era; and how for financial institutions is liquidity management different. There is a certain irony of viewing this from that of a financial institution as the general public would generally consider this post-credit-crunch-era as driven by and/or caused by financial institutions unwillingness to extend credit (despite the Troubled Asset Relief Program (TARP)) , thereby curtailing economic growth and employment. Liquidity or lack there off, is directly impacted by the contraction (high unemployment) of the circular flow of income under macroeconomic theory, i.e. the multiplier effect.
Financial institutions are by definition intermediaries or pass-through entities to some extent in that they sell financial products, and either add interest and/or product features, e.g. life insurance (risk coverage) or auto insurance, and in the case of banks return the deposit funds in full. A bank is a special case because regardless of the state of the economy, the vast majority of consumers require a bank account and/or debit card. As a financial institution, a bank's unwillingness to issue credit cards and/or lend money to small businesses is often viewed as the root cause of this current economic impasse. Financial institutions i.e. banks, would argue from the posture that extending credit in today's environment is unacceptably risky. (Note that there are some very strong counter arguments to this perspective that extends all the way to the government including correctly and theoretically applying Keynesian economics.)
Additionally, it is important to differentiate between financial products that derive from discretionary income such as life insurance/savings vehicles and those driven by legislation such as mandated auto insurance. Liquidity management options need to be directed towards products and/or features that attract that scarce resource cash! The options and/or choices available here, in this post-credit-crunch era, bears uncanny similarity to systematic and unsystematic risk in portfolio theory; where only unsystematic risk can be reduced by diversification. Liquidity management very much depends upon what you can and cannot control.
When viewed from the perspective of maximizing earnings yield on the asset side relative to liability crediting rates, deriving an interest rate spread, liquidity can be considered a sub-optimal strategy. A duration matching strategy will often involve cash or near cash equivalents in order to shorten or match assets cash flows with those of liabilities. It is suboptimal because the greater the cash component in a portfolio the lower the yield; there is an inverse relationship between risk/yields and available cash on hand. Ordinarily, in a non-financial institution, liquidity management would embrace working capital strategies, timing of revenues and expenses as well as liabilities and/or debt management such as credit lines as well as other forms of bridge financing. Bear in mind, it is the small business not the major corporations that are most affected in this credit-crunch era. As a financial institution however, the options for creative management of revenues, inventory and debt management either do not exist or are not practical strategies. Financial institutions have no control over obligated payouts under contractual liabilities (unique to the industry); however financial institutions do have significant control and management of salaries and/or commissions and operating expenses. Senior management in financial institutions can however and do adopt very aggressive cost cutting operating budgets towards reining in expenses and maintaining margins.
As this topic is developed, we will examine other assets and liabilities relative to what liquidity options exist. This post-credit-crunch era also brings with it a significant increase in regulatory compliance, and cost, emanating from the Dodd-Frank legislation and serious curbs to the use of derivatives. Both the latter legislation and the current negative climate regarding derivatives are factors working against liquidity management from the perspective of options and management strategies that used to exist. Unfortunately, in the post-credit crunch era, the government has legislated counterintuitive policies that actually increase costs, i.e. Dodd-Frank and mandated health care coverage legislation, that both further exacerbate the management of liquidity and an economic recovery.
As we consider the topic of liquidity in this post-credit-crunch era, moreover effective management thereof, we need to evaluate how this economic condition effects financial institutions; what is different. There are many sides to this coin! However this recessionary, credit-crunch, condition is analyzed it clearly is not business as usual as in the last decade or two or far longer for most financial institutions. It is also interesting to note, that were this discussion targeted at non-financial entities e.g. regular corporations, it would head in a very different direction. Many corporations (nonfinancial) have unusually healthy balance sheets, in the sense of significant cash balances i.e. the opposite of liquidity problems. It should also be noted that financial institutions, including some major insurance companies, that received TARP monies placed these entities in any relatively healthy liquidity position. The government effectively purchased "weak/underperforming- (mortgage) assets” using taxpayer funds. The objective of this program was to prevent the financial collapse of certain major financial institutions that could have significantly aggravated the already fragile economy.
Before we continue further, we need to reconcile the terms cost and cash. Virtually every year and not just in this current economic environment, financial institutions will go through an annual review of operating expenses i.e. operating costs with the objective of bottom-line savings. The only differentiation, however, between cash and cost is a timing issue. Accountants will allocate, using accruals, costs between two different but consecutive 12-month reporting periods. But relative to this discussion of the post-credit crunch era (not financial reporting period), cost and cash are equal and reducing costs is a liquidity strategy. Note also that the press will refer to the costs of implementing and deploying the Dodd-Frank bill and mandatory health care coverage. Washington has thus legislated, by way of the Dodd-Frank documentation/compliance bill, the equivalent of an increase in taxation and with respect to the health care coverage, a significant increase in employee benefits. Both legislative actions will have a dampening effect upon liquidity. Although these references may appear to have political undertones, they cannot, by definition, be excluded from a discussion of liquidity management in a post-credit crunch era. Their existence and far-reaching ramifications can and will result in strategies to manage liquidity by either opting in or opting out of their application. It has already been noted in the press, that some major hedge funds are reverting to private status as a strategy to avoid the costs of complying with the Dodd Frank bill. Relative to the health care legislation, financial institutions may strategize that it is better to outsource and reduce employee headcount than absorb an increase in employee benefits. There is no simple one line strategy to this liquidity management question and any derived strategies will inherently be multifaceted.