Liquidity in Business Is of Utmost Importance - Essay Example

Introduction

Liquidity in business is of utmost importance. This is because having adequate cash at hand or through items that can be easily converted into cash enables a firm to pay up the most urgent of its liabilities without incurring heavy borrowing costs. However, cash at hand or even in the bank accounts can be considered costly to the business. This fact is not lost to bankers who would prefer a situation where as much cash is used in the lending business to increase the interest spread that leads to higher net interest income. However, the recent economic crisis exemplified the need for banks to have adequate cash reserves to meet the most current business needs.

In the banking crisis that have plagued the world over the last one century, it has become the case that some firms having been willing to exceed the amount of loans appropriate with the deposits made with the bank. They operate under the assumption that deposits will not be withdrawn on short notice and that the bank can handle the withdrawals. However, this has often been far from the truth forcing some to go under and the regulatory authorities to intervene. In Australia, the Australian Prudential Regulation Authority (APRA) has responded by issuing Prudential Standard APS 210 (Liquidity). The most recent release of the standard is similar to the requirements of Basel III liquidity requirements. One of the key requirements of the guideline is that an authorized deposit-taking institution must maintain a quality portfolio of highly liquid assets that meet the firm’s business needs for at least the next one-month (Australian Prudential Regulation Authority, 2014). The regulatory standard also places the task of ensuring that the firm meets the necessary expectations on the hands of the board of directors. At the same time, APS 210 (Liquidity) provides that an ADI must undertake a robust analysis of its funding sources on a regular basis and report the same to the regulator (Australian Prudential Regulation Authority, 2014).

As part of it mandate to have the firm under concrete liquidity risk management, the board must ensure that it meets some minimum quantitative measurements. One, the liquidity coverage ratio must be equal or in excess of one hundred percent (Australian Prudential Regulation Authority, 2014). The implication of such a requirement is that the bank’s high quality liquid assets can meet expected cash outflows for the next one month. High quality liquid assets are defined as those assets that meet the fundamental, market and operational characteristics. On an aggregate, these features include low market and credit risk, can be sold in an active and sizeable market, and are not encumbered (Deloitte Development LLC., 2013).

The second requirement is that the bank must perform a name crisis scenario test that guarantees that the bank will be in operation for at least five days under adverse operating conditions (Australian Prudential Regulation Authority, 2014). Lastly, the board must conduct a going concern analysis that estimates how the business will operate under normal conditions for at least the next fifteen months. This study seeks to explore how well two Australian banks have enforced the requirements of the APS 210 (Liquidity) as well as other regulatory expectations from the APRA. The two banks are the National Australia Bank (NAB), Bendigo, and Adelaide Bank.

Analysis

For the purpose of this paper, the main source of information is the financial reports released by the individual banks. Figure 1 illustrates some of the information pertinent to liquidity risk derived from these annual financial statements for the year ended 2013.

NAB

Bendigo

2013

2012

2013

2012

Interest Income

31,311.00

34,542.00

3,073.70

3,440.80

Interest expense

(17,960.00)

(21,300.00)

(2,046.00)

(2,490.70)

Gross income

13,351.00

13,242.00

1,027.70

950.10

Gross margins

42.64%

38.34%

33.44%

27.61%

Loan impairment charge

1,810.00

2,734.00

69.90

32.40

Loans and advances

411,979.00

394,741.00

49,957.40

48,217.00

Cash and liquid assets

35,666.00

30,130.00

383.80

288.80

Due from other banks

43,193.00

42,018.00

293.90

272.20

Trading derivatives

39,214.00

36,027.00

31.90

48.50

Trading securities

32,996.00

29,494.00

5,465.20

4,366.10

Investments

118,116.00

106,247.00

858.80

833.20

Total assets

808,427.00

762,394.00

60,282.20

57,237.80

Liabilities

Due to other banks

34,623.00

28,128.00

379.50

327.20

Trading derivatives

41,749.00

40,375.00

98.40

179.00

Deposits

446,572.00

425,629.00

47,439.00

44,572.70

Total liabilities

761,807.00

717,693.00

55,848.20

53,020.10

Figure 1: Summary of financial statements

Sources: (Bendigo and Abelaide Bank, 2013; National Australia Bank Limited, 2013)

Owing to the nature and size of its business, NAB naturally has a higher amount of interest income amounting to over AUD 31 billion. While high, interest income for the bank showed a 9% decrease from the previous year’s amount of AUD 34 billion. NAB’s interest expenses amounted to AUD17 billion representing a 15.68% decline. The gross interest margin in 2013 was AUD13 billion, or about 42.63%. In the year 2012, the gross interest margin was 38.34%. Therefore, NAB can be said to have controlled its interest expenses better over 2013 than it did in 2012. Meanwhile, BAB recorded a decline in the amount of interest income as it reduced from AUD 3.4 billion in 2012 to AUD 3 billion in 2013. This was a 10.67% decline. The firm’s interest costs also reduced from a high of AUD 2.5 billion in 2012 to two billion Australian dollars representing a 17% decline in interest costs. However, gross margins increased from 27.61% recorded in 2012 to 33.44% achieved in 2013. Both firms showed a decline in their main line of business, which is traditional lending. This could be attributed to the constrained economic conditions as the global economy recovers from the recession. Current interest rates are at a historic low and the decline in interest margins was observed across the market (KPMG International Cooperative, 2014).

The decline in interest income was realized even as the banks’ loan books increased in size. NAB’s loans and advances increased from AUD 394 billion in 2012 to AUD 412 billion in 2013. This was a 4% increase that was not enough to offset the effects of a low interest environment. On the other hand, BAB saw its loan book increase from AUD 48 billion to AUD 49 billion, which was a 3.6% increase. As with NAB, the increase in the loan book was not enough for BAB to realize an increase in interest income. However, these amounts are always net of the impairment charge on loans and advances. Therefore, it is crucial to carry out an analysis of loan impairment charges by the two banks.

The last two years have seen banks get ready to adopt the new Basel III that have been released by APRA. The result has been a significant reduction in risk appetite within firms and across the industry. For instance, it not common anymore for banks to offer loans without perfuming proper background checks. The result has been a reduction in the amount of loan defaults towards levels seen before the global financial crisis of 2007/2008 (KPMG International Cooperative, 2014). Accordingly, NAB reduced its provision for loan default by AUD924 million over the last two years. This could have been influenced by a run off in the firm’s UK real estate business and the fact that lending practices have improved over the period considered (KPMG International Cooperative, 2014). On the other hand, BAB increased its provision for loan default by 115% from a low of AUD 32 billion in 2012. This is probably because of its consumer loan portfolio in Queensland and the greater western region of Australia that markets pundits have observed to show some signs of distress (KPMG International Cooperative, 2014).

Both banks saw a slight increase in the amount of deposits received from clients. NAB’s deposits increased by AUD21 billion while BAB’s deposits increased by AUD 2.8 billion. In terms of percentage gains, the increases represented a 4.92% and 6.43% for NAB and BAB respectively. With some lines of businesses coming from depression, increases in the amount of deposits is an expected result. Moreover, banks across the country have been pushing to boost the ratio of loans to deposits as the APRA expects them to implement Basel III requirements by January, 2015. On this front, NAB and BAB have been doing remarkably well. For instance, the ratio of deposits to loans for NAB rose from 1.078 in 2012 to 1.084 in 2013. While this is on gross terms, it shows that as one of major Australian banks, NAB is gearing for the adoption of new liquidity requirements set to be adopted in the next one year. Meanwhile, BAB ratio of deposits to gross loans rose from 0.92 in 2012 to 0.94 in 2013. The fact that the ratio is below one shows that that BAB might have problems adjusting to Basel II requirements on liquidity. Low amounts of deposits could be attributed to the nature of its business that shields it from markets accessible to its peers such as NAB. However, BAB has shown improvements in the ratio though it might not be enough when the new laws come into place.

To assess the funding nature of all assets, one might find it prudent to consider the ratio of customer deposits to total assets. This is because customer deposits have to be funded by a line item on the liabilities and equity side of the balance sheet. For NAB, customer deposits made up 55% of all assets on its 2013 books. In 2012, deposits made up a similar amount of all assets. The implication is that the bank could fund more than half of its assets through customer deposits. In contrast, BAB’s ratio averaged 78% and this implies that the bank financed close to 80% of its assets using customer’s deposits. While BAB’s results indicate a better liquidity risk position, this is undermined by the ratio of customer deposits to gross loans.

Over the financial year of 2012/2013, NAB obtained a wholesale funding amounting to AUD25 billion. The funding was obtained in various denominations and it was part of the company’s efforts to shore up its funding capabilities as set out under the proposed Basel III net stable funding ratio (NSFR). Coupled with an AUD15 billion increase in customer deposits, NAB moved closer to achieving the ideal position where it has adequate cash to fund its loan operations. On the other hand, BAB’s financial statements did not indicate any new funding. While it is not possible to deduce the reason for the reluctance to get additional funding to boost its cash position, it can be argued that BAB will have a hard time implementing many of the liquidity measures as proposed by the APRA.

To test liability-side risk, one might consider the ratio of cash and cash equivalents to customer deposits. This is because the risk measures how well a bank is positioned to fulfil its obligations to customers by using the cash it has and selling all marketable securities. Under such conditions, it might not be possible for the bank to recover a significant amount of its loans to clients and it has to sell off its short-term investments to raise necessary funds. Moreover, these are high quality liquid assets whose value is not likely to be affected under normal market conditions. In the case of NAB, the cash and its equivalents accounted for about 60% of gross deposits in the year 2013. In 2012, the percentage was slightly above 57%. The increase can be attributed to an increase across all the bank’s liquid assets. In contrast, BAB ratio of cash to deposits was 14% in 2013 and 13% in 2012. Compared to NAB, BAB was at a worse off credit position. Should the bank face a catastrophe where all its depositors want their money back, BAB will only have sufficient cash to pay an average of 14% of the total demands. On the other hand, should NAB be faced by a similar crisis, the bank can pay off 60% of the total value of deposits and this places the firm in a far much better position than its rival in the market.

The total liquid assets held by NAB as at the close of the 2013 financial year amounted to AUD107 billion. Compared to the previous year, this was a AUD16 billion increase in assets and continues to show that the bank is gearing to achieve the stringent controls set to be enforced in 2015. From the nature of its business, NAB benefited greatly from the appreciation of the Australian dollar as assets denominated in the currency increased by AUD10 billion. As a bank that has mortgages making up a large part of its business, NAB held retail mortgage backed securities as part of its liquid assets portfolio. These securities amounted to AUD27 billion in 2013, up from the AUD20 billion held in 2012. This implies that the bank is seeking to increase the robustness of its liquid assets portfolio to match liquidity expectations of the APRA. The banks also enjoyed credible credit ratings from the major rating agencies. For instance, its long-term debt was rated as AA- by S&P while some of its subsidiaries were rated A+ by S&P. However, Moody downgraded its subordinated debt from Aa3 to A2. Despite this, NAB’s liquid assets portfolio looks healthy for a bank its size.

BAB’s total liquid assets amounted to AUD7 billion in 2013 and AUD5.9 billion in 2012. The increase is an attempt by the bank to meet the new provisions set out in the new laws. The bank also received positive ratings from the three major agencies. Moody’s rating for BAB short-term debt was at P-1 and this means that the bank has no signs of default on this kind of debt. Fitch rated its long-term debt as A- with a stable outlook while S&P rated the bank’s short-term debt as A-2. These ratings indicate that the bank has maintained a positive relation with investors and its business model is viable under current conditions. However, the bank did not disclose the amount held under each class of liquid assets though this might change with the implementation of Basel III in 2015.

Conclusion

NAB had a better income standing than its peer in the banking industry. With a gross interest income of 42.64%, NAB dwarfed BAB’s gross margin ratio of 33.44% in 2013. NAB also perfumed consistently better than BAB on every liquidity risk measure. Owing to better business practices, NAB reduced its provision for bad and doubtful debts by AUD924 million. This was a 33% reduction compared to the 115% increase seen on the books of BAB. This illustrates that on an overall basis, NAB is better placed to adopt the new Basel III regulations that are set to be adopted in the next financial year. BAB’s main concern would be that its ratio of deposits to gross loans is below one. This places the bank in a difficult position as the new regulations require a more robust ratio that is equal to or more than one. From the analysis conducted both BAB and NAB have met the requirements of APRA under current conditions. However, the next financial year might be a problem for BAB as it has problems meeting the stringent controls set out in the new laws set to be adopted in 2015.