Starting a bank is not just about setting up a place where customers can deposit money and access loans. The real challenge lies in managing treasury operations: how you source funds, manage capital, and navigate liquidity risks.
In this series, we ask what it really takes to become a bank, exploring the challenges and rewards, with insight from experts who’ve done it themselves. In our first two articles, we explored the key fundamentals of building a successful banking business and delved into the critical role of the people aspect.
In this, our third instalment, our expert panel Ivan Frampton, Founder and MD at TriFidus; Eddie Trahearn, CFO at GB Bank; and David Bowles, an independent risk consultant, discuss:
why the treasury function is so crucial
how to balance liquidity
the role of a financial model.
Treasury: Get your capital and liquidity in order (and beware hidden costs)
The treasury function is the heartbeat of your financial institution. When you’re setting up a bank, it’s the difference between surviving, thriving or failing outright.
Many novice bank founders are driven by a belief that they can access cheaper and more reliable funding. This is true to some extent, as Bowles explains: “The fundamental draw for these entrepreneurs is the hope of borrowing at rates close to the base rates set by central banks.”
But this view often overlooks the hidden costs and complexities involved in running a bank.
Trahearn highlights: "Some people fail to account for the higher capital required to hold deposits versus other forms of debt, and they often underestimate the increased operational costs required for compliance with regulations.”
Key takeaway: Make sure your business model includes the full costs of being a bank at the outset.
Balancing liquidity when the stakes are high
Bank treasury functions must deal with two challenges that treasury functions in other sectors simply do not face.
Firstly, there is a maturity mismatch between their assets and liabilities. Banks typically receive deposits on a short-term basis – usually with durations of one year or less. They lend money over much longer periods – up to 25 to 30 years, in the case of mortgages. While providing an income margin, this maturity gap presents a liquidity risk if depositors withdraw their money. This is because the assets cannot be converted into cash (liquidity) by the bank at the same speed.
Secondly, there are important behavioural economics on both sides of the bank’s balance sheet. Customers who deposit money (bank liabilities) can withdraw their money at any time; and customers that have taken loans from the bank (bank assets) can repay them early. A bank may manage some of this risk through contractual terms, but it must constantly balance the net impact of various financial goals and objectives of both sets of their customer groups (savers and lenders).
It’s a complex balancing act that Trahearn describes as “a combination of whack-a-mole and solving a Rubik’s cube: you solve for one side (one objective) and turn over (to check other objectives) to find three moles sticking out and someone has moved around all the stickers!”
The situation gets more challenging because unpredictable, macro events can move lots of people’s behaviour in the same direction. “An economic shock, such as a global financial crisis or a pandemic, can cause customers to withdraw funds and/or default on loans at a time when liquidity is already tight,” says Bowles.
Key takeaway: Since no-one can predict when these potential disruptions will occur, Treasury management in a bank requires ongoing stress testing and risk management to ensure the bank remains resilient to liquidity events.
Financial modelling in treasury management
Effective financial modelling is critical to the management of a bank's treasury function. This process enables banks to better navigate financial uncertainties by quantifying risks and allowing for proactive planning.
“A good financial model will show the financial impact of various risks, allowing your bank to remain resilient in the face of market disruptions," notes Trahearn.
Frampton expands on this idea, explaining that a robust financial model essentially functions as a digital simulation of the bank’s products and operations. "The model is built from the ground up, reflecting the fundamental drivers of the business. It is linked with systems containing historical financial actuals and integrated within a bank’s forecasting processes.” It must be a core part of an integrated approach to stress testing and financial management.
Regulators now expect this functionality as standard. Banks are required to perform stress tests and demonstrate financial resilience before and continuously after they are granted authorisation. Ultimately, strong financial modelling not only improves compliance, but also enhances financial resilience, helping banks navigate market pressures and avoid costly errors.
Key takeaway: A driver-based and integrated financial model provides treasury teams with a powerful tool to evaluate the effects of stressed scenarios and plan counter-strategies.
Summary
Offering access to cheaper, more reliable funding is a common motivation to set up a bank, and an important one. It has its place, but the regulatory environment will introduce capital, liquidity and operating costs you must anticipate.
For a bank to thrive, its treasury function needs to solve the two key funding challenges unique to a bank’s business model: (1) the maturity mismatch, and (2) anticipating the behaviour of both groups of its customers (borrowers and savers) that can be heavily influenced by macro events.
To ensure the bank is resilient during economic downturns, regulators expect treasury teams to stress test scenarios using advanced financial models. You’ll need to make sure yours are up to scratch if you are to remain compliant.
Look out for our next article in the ‘What it takes to become a bank’ series, taking a deeper dive into bank regulation.
If you need advice on setting up a bank, from your business plan to your financial model, TriFidus can help. Contact our specialists today.
All views expressed are personal and do not necessarily represent the views of interviewees’ organisations.