Liquidity in nostro accounts

Liquidity is the most practical problem in correspondent banking, and it is the problem that operations and treasury teams spend most of their time managing. A nostro account must have enough balance to fund the payments that will be sent from it today, but holding too much balance is wasteful, because money sitting in a nostro account earns little or no interest and could be used elsewhere. The treasury team must forecast the payments that will go out and the payments that will come in, and must fund the account to cover the net outflow, with a buffer for unexpected payments. If the forecast is wrong and the balance runs out, payments will be queued or rejected, and customers will be disappointed. Funding a nostro account is itself a payment, and it takes time. To increase the dollar balance in New York, a bank in India must send dollars from another account or buy dollars in the foreign exchange market and settle the purchase into the nostro account. The funding payment is a bank to bank transfer, a pacs.009 or an MT202, and it must be arranged before the payments go out, which means the treasury team works a day ahead, forecasting tomorrow's payments today and funding the account tonight. The cut off times of the correspondent matter here. A funding payment that arrives after the correspondent's cut off will not be available until the next day, and a funding payment that arrives after the local clearing cut off may not settle until the day after that. Consider a worked example. A bank in India expects to send USD 40,000,000 in dollar payments tomorrow and to receive USD 32,000,000 in dollar receipts. The net outflow is USD 8,000,000. The nostro balance tonight is USD 12,000,000, so the account can cover the net outflow with USD 4,000,000 to spare. But the receipts are expected late in the day, after the morning payments have already gone out, so the intraday low point is USD 12,000,000 less the morning outflow of USD 25,000,000, which is negative USD 13,000,000. Treasury therefore funds USD 15,000,000 tonight, or arranges an intraday credit line of USD 15,000,000, so that the morning payments can go out. The forecast is not about the end of day balance, it is about the lowest balance during the day, and that is the number that matters. The correspondent allows the respondent to overdraw the nostro up to an agreed limit during the day, on the understanding that funds will arrive later. The limit is set by the correspondent based on the respondent's credit quality, and it has a price, usually a fee per day plus interest on the overdrawn amount. The hard deadline is the end of the correspondent's business day, by which the account must be back in credit. If the account is still overdrawn at the deadline, the correspondent charges penalty interest, may refuse further payments, and will report the breach to its credit team. The analyst must know the intraday limit for each nostro, because it decides how many payments can be sent before funding arrives. Sweeps and pooling are the tools that reduce idle balances. A sweep moves surplus funds from a nostro account to a central funding account at the end of the day, so that the money can be invested overnight instead of sitting idle. A pool combines the balances of several nostro accounts in the same currency into a single available balance, so that a payment can be funded from whichever account has funds. Both tools need system support, and both need to respect the correspondent's rules, because some correspondents require a minimum balance to be maintained. The analyst who writes requirements for treasury should include the sweep rules, the pool rules, and the minimum balance per account. The cost of holding liquidity is also a reason why cross border payments are more expensive than domestic payments. A domestic payment settles in central bank money within the same country and the same day, so the liquidity need is small. A cross border payment sits in a nostro account, sometimes for days, while the payment is processed, cleared and settled. The bank charges the customer for the payment, for the foreign exchange, and for the use of its balance sheet, because all three have a cost. A bank that holds USD 500,000,000 across its nostro accounts at an average funding cost of 4 percent a year is paying USD 20,000,000 a year for that liquidity, and that cost is built into the price of every payment. New models aim to reduce the need to hold large nostro balances by settling payments directly between central banks, including payment system linkages and central bank digital currency arrangements such as mBridge. These models are still in development and cover only a small number of corridors, but they show the direction of travel. For now, the nostro account and the liquidity it holds are the engine of cross border payments, and the analyst must understand how that engine is funded, how it is forecast, and how it is monitored. The daily liquidity dashboard, showing every nostro balance, the reserved amount, the forecast low point, and the headroom left, is the single most important screen in the treasury function. Payments queue in the payment engine, the queue grows through the morning, customers call to ask where their money is, and operations must decide which payments to release and which to hold. The release order is usually by value date, then by customer priority, then by amount, and the decision is logged. A bank that has no liquidity policy will release payments in the order they arrived, which can mean a small retail payment goes out while a large corporate payment that must settle today is held. The analyst must specify the queueing and release rules, the priority order, and the escalation when the queue exceeds an agreed threshold, because liquidity failure is not a rare event, it is a normal operational risk that must be designed for.