A.BATZORIG: HOW RECENT ‘CREDIT CRUNCH’ (2007/2009) HAS AFFECTED THE STRATEGY AND LIQUIDITY MANAGEMENT OF THE BANKS

During the crisis, the global financial system experienced urgent demands for cash/liquidity from various sources which include numerous financial counterparties, short-term creditors, and especially, existing borrowers. It was particularly acute for banks, given their highly leveraged lending from short-term funding. Some of the crisis roots such as house price overvaluation and asset price collapse in the US worsened the situation since assets acts as the collateral for much of the bank’s lending and a possible basis for loss in respect to asset market value. Additionally, there was a massive increase of financial leverage from innovations like collateralized debt obligations (CDOs) and mortgage-backed securities (MBSs) that multiplied the impact of the crisis. It is also believed that credit rating agencies such as Moody and S&P played a very important role on various stages of the subprime crisis. Many analysts have blamed the move from traditional ‘buy and hold’ to the new ‘originate-to-distribute’ lending model of the banks for credit expansion. Overall, financial innovations lead to complex products which were vaguely understood by investors, which in turn generated large increase in the availability of credit, which in turn fuelled asset bubble in the real estate. Consequently, the crunch was further intensified when the investors lost confidence in products and withdrew, leaving the banks and other borrowers short of funding and, thus, holding large quantities of now illiquid assets.

Arising from the crisis, many banks faced liquidity risk and risk management of assets and liabilities (ALM) in general. Traditionally, bank is exposed on liquidity risk in the event of deposit base shrinkage such as a “run” (depositors making sudden withdrawals due to lack of confidence in the institution) and poor cash inflow from the credit portfolio (due to delinquency). This situation is often termed as “credit crunch”. Another type of liquidity risk becomes more important from the bank’s exposure to a range of new and innovative lending and interbank financial arrangements. These include undrawn loan commitments (off-balance sheet), obligations to repurchase securitized assets, margin calls in the derivatives markets, and withdrawal of funds from wholesale short-term financing arrangements. The banks which were more exposed to this liquidity risk were forced to increase their holdings of liquid assets the most to stabilize any risk of deposit run. They also reduced new lending to a high extent. In general, banks were holding assets with low liquidity, such as MBSs, expanded their cash buffers during the crisis and decreased new lending on their asset side. They protected themselves by hoarding liquidity, to the detriment of borrowers. On the liability side, the banks that relied more heavily on wholesale sources of funding (purchased liquidity management) suffered more than the banks that relied predominantly on traditional deposits and equity capital for funding.

It is important to distinguish between asset liquidity and funding liquidity. Liquid assets can be easily sold to raise cash. However, illiquid assets cannot be sold or only at very poor prices. Funding liquidity is about the reliance on other lenders to finance the balance sheet. Borrowing longer term means that funding cannot be withdrawn at short notice just when it is needed. Funding liquidity risk is reduced by longer term lending, having many diverse sources of funding and ensuring plenty of excess capacity in the event of emergency.

As the banks learned from the crisis, effective changes to risk management practices are vital. The Basel committee has highlighted some new requirements on the liquidity risk management and other risk types. To strengthen the effectiveness of management of liquidity risks, the Basel Committee has developed two basic standards: First is the Liquidity Coverage Ratio which focuses on short term liquidity by limiting the ratio of banks’ high quality liquid assets to expect net cash outflow over a 30-day period under an acute stress scenario to be at least 100%. Second is the Net Stable Funding Ratio which is to promote a more compatible maturity structure of assets and liabilities and to limit over-term assets. It requires banks to maintain a ratio of available stable funding to the required amount of stable funding of at least 100%.

Conclusion and lesson from crisis: The banks are important institutions that tremendously contribute to the economy development and growth, and thus, they have a high responsibility for not creating roots that could generate and result in financial crisis and credit crunch. With that said, the banks are deliberately required to focus on following concepts:

1. First of all, the bank needs to remember that crisis is originated from credit default or borrowers’ slow loan repayment process. Therefore, it is very important for banks to focus on heightening its loan requirements and conducting accurate assessments of borrowers’ repayment capability. The banks should also ensure adequate down payment from mortgage loan applicants in order to obtain secure collateral coverage ratio on the loans. On the other hand, heightened collateral requirement could positively result borrowers’ attitude and behaviour to repay loans on time.
2. Speaking from my experience, it is very useful for banks to conduct frequent analysis to predict market trend in real estate price to its bubble sign. Such preventative steps from risks are essential to be in place and banks should avoid unlimited expansion of their loan portfolio as it could fuel bubble in real estate price similar to the credit crunch of the 2007/2009 period.
3. In general, deregulation and loan growth intensification should be considered from the risk management perspective. The point is that any negative affect and its trend in bubble sign or inflation rate growth has to be precisely analyzed in a timely manner. As in Mongolia, the regulatory has tendency to raise policy or benchmark rate in the event of increased trend in inflation and in order to curb such increase, local commercial banks heighten their lending requirements and increase lending rate.
4. The bank’s management and key staffs should always be aware of the necessary liquidity to make available for the business and it is essential for the bank to remain in alignment with future liquidity requirement. At the same time, the bank should ensure adequate buffer for abnormal or severe liquidity condition as to prevent credit crisis in full swing. Moreover, the bank has to monitor lead liquidity indicators in its external environment and to plan its capital raising efforts.
5. In the world of advanced risk management, it is extremely important for the banks and financial institutions to be disciplined in respect to integrated risks management of all banking risks such as credit, operational, market and liquidity risks as well as to concentrate all risks in the circle relationship. Such integrated management of risks and proper risk management infrastructure within good governance principal is fundamental in the financial market system. 
6. Governance of the bank is vital important in the bank, as we have been locally experienced in difficulty of banks in last two decades. Until 2007, deregulation was widely populated in place and banks were internationally oriented in growing trend that actually led to miss out governance principal implementation. Board sophistication and attitude on risk awareness idea is considered to be chief indicator of proper financial institutions and setting of policy and appetite in risk management framework become more challenging during the period in crisis, and that is basically relevant to ethical sides of human nature.

During the crisis, the global financial system experienced urgent demands for cash/liquidity from various sources which include numerous financial counterparties, short-term creditors, and especially, existing borrowers. It was particularly acute for banks, given their highly leveraged lending from short-term funding. Some of the crisis roots such as house price overvaluation and asset price collapse in the US worsened the situation since assets acts as the collateral for much of the bank’s lending and a possible basis for loss in respect to asset market value. Additionally, there was a massive increase of financial leverage from innovations like collateralized debt obligations (CDOs) and mortgage-backed securities (MBSs) that multiplied the impact of the crisis. It is also believed that credit rating agencies such as Moody and S&P played a very important role on various stages of the subprime crisis. Many analysts have blamed the move from traditional ‘buy and hold’ to the new ‘originate-to-distribute’ lending model of the banks for credit expansion. Overall, financial innovations lead to complex products which were vaguely understood by investors, which in turn generated large increase in the availability of credit, which in turn fuelled asset bubble in the real estate. Consequently, the crunch was further intensified when the investors lost confidence in products and withdrew, leaving the banks and other borrowers short of funding and, thus, holding large quantities of now illiquid assets.

Arising from the crisis, many banks faced liquidity risk and risk management of assets and liabilities (ALM) in general. Traditionally, bank is exposed on liquidity risk in the event of deposit base shrinkage such as a “run” (depositors making sudden withdrawals due to lack of confidence in the institution) and poor cash inflow from the credit portfolio (due to delinquency). This situation is often termed as “credit crunch”. Another type of liquidity risk becomes more important from the bank’s exposure to a range of new and innovative lending and interbank financial arrangements. These include undrawn loan commitments (off-balance sheet), obligations to repurchase securitized assets, margin calls in the derivatives markets, and withdrawal of funds from wholesale short-term financing arrangements. The banks which were more exposed to this liquidity risk were forced to increase their holdings of liquid assets the most to stabilize any risk of deposit run. They also reduced new lending to a high extent. In general, banks were holding assets with low liquidity, such as MBSs, expanded their cash buffers during the crisis and decreased new lending on their asset side. They protected themselves by hoarding liquidity, to the detriment of borrowers. On the liability side, the banks that relied more heavily on wholesale sources of funding (purchased liquidity management) suffered more than the banks that relied predominantly on traditional deposits and equity capital for funding.

It is important to distinguish between asset liquidity and funding liquidity. Liquid assets can be easily sold to raise cash. However, illiquid assets cannot be sold or only at very poor prices. Funding liquidity is about the reliance on other lenders to finance the balance sheet. Borrowing longer term means that funding cannot be withdrawn at short notice just when it is needed. Funding liquidity risk is reduced by longer term lending, having many diverse sources of funding and ensuring plenty of excess capacity in the event of emergency.

As the banks learned from the crisis, effective changes to risk management practices are vital. The Basel committee has highlighted some new requirements on the liquidity risk management and other risk types. To strengthen the effectiveness of management of liquidity risks, the Basel Committee has developed two basic standards: First is the Liquidity Coverage Ratio which focuses on short term liquidity by limiting the ratio of banks’ high quality liquid assets to expect net cash outflow over a 30-day period under an acute stress scenario to be at least 100%. Second is the Net Stable Funding Ratio which is to promote a more compatible maturity structure of assets and liabilities and to limit over-term assets. It requires banks to maintain a ratio of available stable funding to the required amount of stable funding of at least 100%.

Conclusion and lesson from crisis: The banks are important institutions that tremendously contribute to the economy development and growth, and thus, they have a high responsibility for not creating roots that could generate and result in financial crisis and credit crunch. With that said, the banks are deliberately required to focus on following concepts:

1. First of all, the bank needs to remember that crisis is originated from credit default or borrowers’ slow loan repayment process. Therefore, it is very important for banks to focus on heightening its loan requirements and conducting accurate assessments of borrowers’ repayment capability. The banks should also ensure adequate down payment from mortgage loan applicants in order to obtain secure collateral coverage ratio on the loans. On the other hand, heightened collateral requirement could positively result borrowers’ attitude and behaviour to repay loans on time.
2. Speaking from my experience, it is very useful for banks to conduct frequent analysis to predict market trend in real estate price to its bubble sign. Such preventative steps from risks are essential to be in place and banks should avoid unlimited expansion of their loan portfolio as it could fuel bubble in real estate price similar to the credit crunch of the 2007/2009 period.
3. In general, deregulation and loan growth intensification should be considered from the risk management perspective. The point is that any negative affect and its trend in bubble sign or inflation rate growth has to be precisely analyzed in a timely manner. As in Mongolia, the regulatory has tendency to raise policy or benchmark rate in the event of increased trend in inflation and in order to curb such increase, local commercial banks heighten their lending requirements and increase lending rate.
4. The bank’s management and key staffs should always be aware of the necessary liquidity to make available for the business and it is essential for the bank to remain in alignment with future liquidity requirement. At the same time, the bank should ensure adequate buffer for abnormal or severe liquidity condition as to prevent credit crisis in full swing. Moreover, the bank has to monitor lead liquidity indicators in its external environment and to plan its capital raising efforts.
5. In the world of advanced risk management, it is extremely important for the banks and financial institutions to be disciplined in respect to integrated risks management of all banking risks such as credit, operational, market and liquidity risks as well as to concentrate all risks in the circle relationship. Such integrated management of risks and proper risk management infrastructure within good governance principal is fundamental in the financial market system. 
6. Governance of the bank is vital important in the bank, as we have been locally experienced in difficulty of banks in last two decades. Until 2007, deregulation was widely populated in place and banks were internationally oriented in growing trend that actually led to miss out governance principal implementation. Board sophistication and attitude on risk awareness idea is considered to be chief indicator of proper financial institutions and setting of policy and appetite in risk management framework become more challenging during the period in crisis, and that is basically relevant to ethical sides of human nature.