Suits the C-Suite
Managing liquidity risk in today’s environment
After several years of abundant and cheap liquidity, banks are facing new liquidity risk management challenges in today’s rapidly changing environment. Between June 2022 and May 2023, the Philippine benchmark interest rate moved from 2.5% to 6.25%. Similar interest rate trends have been noted across the Asean markets, impacting bank balance sheets and creating tougher economic conditions for customers. Borrowers are dealing with increased loan payments on variable-rate loans, decreased savings rates due to inflation, and general uncertainty about economic conditions.The recent data are tracking significant growth in bank fixed-income securities investments, which are susceptible to unrealized losses in a rising interest rate environment. Securities growth was 60% from April 2020 to April 2023. Banks hold these securities to collect cash flows from interest and principal, but long-term securities with large unrealized losses are not typically sold to avoid realizing a loss. Thus, these investments do not represent true access to liquidity, unless banks undertake repurchase agreements at market value.Another factor driving up liquidity risk was demonstrated in the recent overnight failure of certain US banks. The sudden collapses show how, in the age of instant communication and social media, a financial panic can go into hyperdrive, facilitated by the ability to make instantaneous bank transfers and withdrawals.Although underlying problems caused the failure, banks need to recognize the additional liquidity risks now that social media has become interwoven into our social and financial lives. In an analog, bricks-and-mortar world, the US banks in question could arguably have had time to reach out to (and be propped up by) the Federal Reserve. But the speed at which social media fanned the flames of customer panic meant that, by the time banks opened the next morning, it was already too late to save them.Conditions can change quickly. Banks must stay on top of their liquidity management. TRADITIONAL STRESS-TESTING ASSUMPTIONSBanks need to take another look at their liquidity stress testing assumptions in light of:• The new speed of bank runs given the evolving role of technology in banking, including the ability of social media to turn a drama into a crisis. All the evidence suggests that a bank run precipitated by social media has the potential to cause even a healthy bank to fail in a matter of days.• The inflationary environment, with some observers predicting interest rates could climb into the low — or even the high — teens.• The potential need to support entities or funds, such as money market funds or unit investment trust funds (UITF), even though banks are not contractually obligated to do so.The new reality in which banks find themselves operating means current estimates of their contingency funding requirement may be significantly too low. They may also be underestimating the need to deal with intense media coverage or to incorporate reputation risk considerations into funding decisions. At its core, a contingency funding plan (CFP) is a crisis management tool. The plan should set out strategies management expects to use to address liquidity shortfalls. In this environment, now is a good time for banks to review their CFP and test its operational components.When updating stress testing, it’s vital not to ignore the worst-case stress tests. Monitoring and reporting functions are normally performed routinely, by the numbers on hypothetical, forward-looking scenarios. Management should look beneath the surface to highlight potential problems. Banks can no longer afford to “play it safe” with liquidity.The point is stress tests are not predictions. These are not events we think will likely eventuate. They are tools for revealing vulnerabilities — which means we must base them on worst-case scenarios. For example, what would the balance sheet look like if 80% of depositors pulled out their funds in a short period of time? It’s important to assess the impact of extreme but plausible scenarios like this on an institution’s earnings, liquidity, and solvency positions.SOLVENCY AND LIQUIDITY ARE TIGHTLY INTERTWINEDBanks also need to think more deeply about the link between their solvency and liquidity, which affects their liquidity buffer. The liquidity buffer is a pool of ear-marked, high-quality, and liquid assets used to meet immediate liquidity needs when faced with adverse conditions.Capital is not a substitute for liquidity. But the two are very closely intertwined. The more solvent a bank is, the less likely will a run ensue. Therefore, the weaker a bank’s solvency position, the more careful the bank has to be about maintaining a higher capital buffer.Apart from solvency concerns, the size of the liquidity buffer is also affected by a bank’s survivability horizon and risk appetite. The board should have a view on how long the bank is intended to survive a stressful environment when there is no access to new wholesale funding. Discussing these types of conditions will help to determine the size of the liquid asset buffer the bank needs. BUILDING LIQUIDITY RISK INTO DECISIONSIn tackling this issue, bankers should ensure liquidity risk strategies are clearly articulated and understood throughout the institution, especially in business units that generate and consume liquidity. This will help to drive corporate strategy that addresses liquidity risk and prudent business decisions. Otherwise, there may be gaps between business and financial plans, which can greatly weaken liquidity positions in the current environment.For example, institutions may not adequately prepare for the implications on the liquidity of actions taken in normal business activities, like focusing on a new customer segment, or strategic initiatives, like acquisitions or entering new markets. Liquidity costs must also be taken into account to more accurately reflect the true costs of products and services, leading to more appropriate deposit pricing.For banks looking to embed liquidity risk into day-to-day business decision-making, incentives can play an important role. Are targets sufficiently designed to achieve an appropriate balance between risk appetite and risk controls? Between short-run and longer-run performance? Or between individual or local business unit goals and firm-wide objectives?UNDERSTANDING BANK FUNDING RISKAn important piece of managing liquidity risk is to understand how the bank is funding its balance sheet. Normally, this involves a mix of core deposits, noncore deposits, wholesale funds and equity. Management should understand concentration risks, including large fund providers or large depositors, concentrations to certain industries, concentrations of noninsured deposits or concentrations in certain types of wholesale funding. Part of the CFP should be potential responses to those concentration and funding risks. Deeply knowing your customers and a study of historic deposit behaviors can also help the bank understand the expected maturities on its deposits. DATA QUALITY MAY NEED TO BE ADDRESSEDThe experience of helping banks to assess liquidity risk in institutions around the region highlights the need to address data problems. Accurate risk assessment depends on aggregating data across multiple systems to develop a group-wide view of liquidity risk exposures and identify constraints on the transfer of liquidity within the entire banking group.If banks are adjusting their stress-testing scenarios and assumptions, this is also an opportunity to check the validity and accuracy of data used in all reports feeding into liquidity risk management. Improving the accuracy of liquidity metrics and liquidity positions can identify significant liquidity opportunities.INDEPENDENT REVIEW OF LIQUIDITY RISK MANAGEMENTFinally, in a rapidly changing environment, an independent review can be helpful to evaluate liquidity risk management processes for their alignment with regulators’ guidance and industry sound practices.All these efforts will deliver strong returns on their investment. The better banks manage liquidity, the less it will cost — an increasingly important differentiator in today’s market. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co.Vicky B. Lee-Salas is a partner of SGV & Co.
Read more
How embedded finance elevates the customer experience
The global market continually evolves as customers look for ways to better integrate financial services into their daily lives. Consumers now prefer a holistic customer journey rather than siloed transactions. As such, banks and other financial institutions must identify opportunities in this developing ecosystem to stay competitive and drive long-term growth.On a micro-scale, individuals can locally use e-wallets and online banking apps to send and receive money, pay bills, and perform cashless transactions on their mobile phones. These integrated experiences have evolved past digital financial services, bringing us closer to the next economic revolution.NOVEL FINANCIAL EXPERIENCESNon-financial organizations have started recognizing the value of offering seamless financial services to meet the needs of “digital citizens.” These businesses are now capitalizing on customer data and analytics to boost brand loyalty, generate new growth, and refine the customer experience. In this new age of technology-driven finance, services are most effective when delivered conveniently and frictionlessly.Changing and developing customer expectations are driving this new era of integrated finance. E-commerce platforms, online marketplaces, and retailers are starting to embed financial products and services into their end-to-end customer journeys.Fundamentally, embedded finance involves a non-financial services company integrating financial products or services into its value chain to bolster its customer experience.According to an EY market survey, with respondents from 21 technology providers across the Americas, EMEIA, and APAC, 94% of global financial technology leaders said that addressing customers’ needs in real time is a significant feature of financial products. As such, there is a burgeoning interest for financial and non-financial institutions to collaborate and identify opportunities for mutual growth. Additionally, EY financial research predicts the valuation of global embedded finance to grow from $264 billion in 2021 to $606 billion in 2025.THE RISE OF EMBEDDED OFFERINGSBanking-as-a-service (BaaS) providers use modern application program interfaces (API) to provide regulated banking solutions to non-financial institutions. These platforms and related technologies make it easier for financial technologies (Fintechs) to work with brands. The advancement of cloud computing and the omnipresence of mobile devices enables considerable connectivity between brands and consumers.Moreover, other integrated value propositions are on the rise. For example, a local e-commerce platform allows buyers and merchants to transact within its mobile app through its e-wallet feature. This service eliminates the need for a separate, traditional bank account. Another example is what started as a ridesharing app, but which now has transitioned to payments, food delivery, e-wallets, and more. Furthermore, the EY market survey shows that over 70% of respondents think that non-financial institutions will offer more financial products and services in the future.For a non-financial services company, having customer transactional data can help the organization create bespoke offerings for its consumers. Online marketplaces, retailers, and software companies, among others, are expected to play a crucial role in the future of the finance sector. Hence, organizations must rethink their positioning, strategic vision, and value propositions to capitalize on this nascent market opportunity.THE VALUE OF PAYMENTSEmbedded finance is manifold, but payments are the most significant in terms of revenue. According to EY research, the value of embedded-channel payments will grow to $6.5 trillion by 2025 from $2.5 trillion in 2021. Non-financial businesses make use of payments as the first touchpoint of customer transactions. With various offerings like discounts, gifts, and pre-orders, payments can help an organization create new experiences and increase customer retention. Furthermore, brands can integrate other services like insurance into this transactional flow the further it evolves.Likewise, consumers worldwide have increasingly adopted the use of digital wallets. This development has revolutionized the payment process for customers and merchants. According to an EY report, The Rise of Paytech — seven forces shaping the future of payments, mobile commerce comprised 52% of e-commerce spending, surpassing that of desktop users. Mobile wallets also held a 49% share in worldwide e-commerce payments in 2021. Finally, according to Juniper Research, an analyst house specializing in digital technology market research, the number of digital wallet users globally may exceed 5.2 billion by 2026, up from 3.4 billion in 2022.THE ROLE OF FINANCIAL SERVICES PROVIDERSEmbedded finance is a disruption that forces traditional financial institutions like banks to embrace this development. It is crucial for banks to adapt, as non-financial institutions have shown that they can now occupy the traditional role of banks. Brands that integrate finance into their customers’ end-to-end journeys create a convenient and robust user experience, which can cement their place in the global market.Once organizations clearly grasp their capabilities, leaders can devise strategies to incorporate embedded finance in the following ways:1. Customer- or product-centered approach This is a traditional model where banks can extend their services to others while innovating their core offerings. This approach means financial institutions are agile and introduce new products that will retain their customer base as market conditions evolve.2. Enabler approachThis approach centers on banks extending their products and services via a platform business model. Additionally, they must set up a digital set of core offerings while embedding services into other third-party platforms. By doing so, banks must understand which products and services could synergize with third-party platforms. They also need to consider various partnership models based on their existing capabilities.3. Builder approachThis technology-heavy approach involves the creation of platforms that house internal and external products. This method relies on agility and functionality as the model continuously adapts according to third-party functionalities. The bank must consider what offerings they can build in-house and which ones they must outsource. 4. Owner orchestrator approachIn this scenario, the bank owns the platform and customer distribution channels while also delivering its products. As such, it must invest in the right technology to bolster customer interactions. This method requires a scalable operating model that continuously improve the functionalities. The bank needs to measure the platform’s success and identify ways to increase brand recognition and retain customers.The conundrum that banks face is that consumers are opting for embedded channels to tap financial services. Financial institutions must find ways to innovate their products and services, lest they fall behind. As the digital age progresses, banks and other institutions should seize the opportunity to differentiate themselves from their competitors. Ultimately, innovation will drive the advancement of financial services toward integrated customer experiences. The discrepancy between what brands offer and what consumers want creates an opportunity for organizations to develop a new strategic vision to drive long-term growth. Banks and other organizations can explore new options, reimagine offerings, and embrace non-traditional revenue channels as they pivot to a financially embedded world. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co.Janet A. Paraiso is an assurance partner and the FSO assurance leader of SGV & Co.
Read more
Effective internal controls: A vital enabler for private companies
Change is inevitable, and we know this now more than ever. The technological disruptions that were hastened by the exigencies of the pandemic have now become widely accepted and mainstream, with such changes continuing to grow more rapidly each day.The pace of change in organizations has also accelerated. As a response to risk events such as cybersecurity breaches and fraud, especially during the pandemic, organizations had to quickly reinforce controls to protect their assets and manage compliance, reputational and legal risks. Regulatory activities have increased over the last several years in response to these events, and recently, as a result of corporate failures from previous decades, have become a race to adopt a compliance-focused mindset.With the pandemic slowing down, some companies are now re-aligning risk management with changes in business models and emerging risks in the face of disruption and technological advancements. This is challenging for private companies, especially for small- and medium-sized enterprises (SMEs), which are recovering lost growth and managing transitions to more resilient business and operating models while simultaneously meeting new demands from internal and external stakeholders.Private companies have an opportunity to clarify or reinforce the roles and responsibilities within their internal control environment, stressing that management is responsible for internal controls. Enhancing internal controls by formalizing ad hoc practices, creating units or departments that will complement the monitoring functions of existing business units (such as the compliance department or risk management unit) or strengthening internal audit are some ways to respond to the emerging risks. Controls need to respond to the challenges of ever-changing business and regulatory landscapes. Private companies cannot just focus on growth today; they need to level up to ensure they protect their future.CREATING A WELL-DEFINED GOVERNANCE STRUCTUREClear reporting lines and a strong governance structure play important roles in any organization’s internal control environment. A well-defined governance structure provides an end-to-end view of stakeholder involvement by clearly assigning process ownership and accountabilities, identifying the roles and those responsible for responding to risks, and ensuring that controls are working. It also describes how performance ratings of the control owners are linked to the effectiveness of the controls for which they are responsible.Since maintaining a strong internal control environment normally involves people who work in various functions within the organization, the governance structure of a private company should be designed such that it enables effective coordination and communication across various business units. Having a well-defined governance structure in place also facilitates the timely reporting and analysis of any observations and findings on the effectiveness of controls. This in turn helps ensure that any weaknesses and deficiencies are identified, appropriate risk and impact assessments are performed, and remedial action is taken and implemented.PERIODIC REASSESSMENTWhen governance structures and internal controls are not regularly reassessed, private companies may struggle to keep up with the pace of disruption and change. With today’s dynamic operating environments, controls that worked in the past may no longer be as effective today.As complexity and disruption continue to rise in business, performing periodic reassessments enables private companies to evaluate whether the owners and management still have the appropriate level of oversight over business processes. It also helps private companies assess whether their current structure still fosters a culture of risk awareness and whether internal controls still work as effectively as intended. By periodically reassessing internal controls and their governance framework, private companies can also identify opportunities for improvement and optimization. This includes automating certain processes and controls as well as updating the controls mix in response to changes in the business.AGILE RESPONSEPrivate companies should stay on top of the changes in business, regulatory, tax and financial reporting requirements, and weigh any possible resulting risks to the organization. It is important that private companies have a process to identify these changes early and communicate them to those responsible for related processes and controls.By being proactive, private companies can timely assess the impact of changing regulatory requirements on various functions across the organization, such as governance, technology, people, policy, processes and controls. This also helps facilitate an appropriate interpretation of the changes and their application to the business, enabling management to evaluate whether the current internal control environment remains adequately equipped to respond to the changes.Private companies can stay abreast of these changes by regularly monitoring updates from organizations such as the Philippine Financial and Sustainability Reporting Standards Council (FSRSC) for accounting standard updates, the Securities and Exchange Commission (SEC), the Bureau of Internal Revenue (BIR) and other regulators for new developments and updated regulations. Private companies need to empower their C-suites, such as chief financial officers, chief risk officers or chief legal officers, to proactively discuss changes with the board and craft related action plans. When evaluating the impact that the changes have on the organization, private companies should also closely coordinate and work with their external advisors, experts and even external auditors to ensure that a holistic view of the impact is being considered.TALENT RETENTION AND UPSKILLINGThe success of sustaining an effective control environment also depends on the resources involved. Given the pace of change, private companies may need a workforce with a broad range of skills and competence. It is therefore important for private companies to consider whether current skillsets in the organization are sufficient in addressing its changing requirements. Given their growth strategies and the anticipated changes in their business, private companies should also consider whether these are the same skillsets they will need in the future to maintain an effective control environment.Any gaps in skills should be evaluated for their impact on the organization. Similarly, the organization should identify solutions that can address gaps, such as expanding the sources of talent and upskilling the current workforce through partnerships with training and learning providers.For private companies that are implementing new processes or migrating manual processes to technology-enabled solutions, it is important that, as part of the transition, the organization also evaluates whether the resources selected to monitor the scope and mix of internal controls continue to possess the necessary skills and competence.BUILDING CONFIDENCE IN INTERNAL CONTROLSThe ability to respond to the challenges of today and the future by identifying and managing risks early is a vital enabler of success for any business regardless of its stage of growth. Since businesses with strong and effective internal control environments are in a better position to timely identify and mitigate risk, it is increasingly important for private companies to build confidence in their internal control environment if they are to succeed in navigating business and industry disruptions. Having effective internal controls, especially on financial reporting, builds confidence in the information that management uses. Suffice it to say, timely and reliable financial information are crucial in making impactful business decisions.Investing now to manage the risks of the present and beyond is as crucial as spending to grow a business. In the long run, a strong and effective governance and internal control framework that is responsive to the changing business and regulatory environments will enable private companies to continually build and strengthen the right foundation to support their growth ambitions, comply with regulations, sustain long-term profitability and protect company value. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.Kristopher S. Catalan is an assurance partner and the EY private leader of SGV & Co., and Dwayne G. Ignacio is a manager from the Financial Accounting Advisory Services (FAAS) of SGV & Co.
Read more
Recommended
Publications
Doing Business in the Philippines 2023 (English)
01 December 2023
SGV’s Doing Business in the Philippines brochure presents an overview of the country’s economy, labor force and laws relevant to investors, with updates and trends on various industries.
Download PDF
