The Bank as a System
Forty years ago, Dr. James V. Baker wrote about systems theory development in his original work on asset/liability management. He illuminated the idea that a bank is a system of complex relationships that cannot be analyzed in complete isolation. The output of one decision serves as the input for another. If, for example, an investment decision robs the balance sheet of flexibility with respect to capital management or liquidity, then the net effect may be to wipe out whatever yield the investment promised. It seems more prudent to take a step back and look at the total bank and all of its characteristics.
The first order of business is to examine the asset/liability management posture of the bank. We must determine how the balance sheet is situated with respect to re-pricing and maturing volumes of assets versus liabilities. This includes the rates we are earning and paying on those balances, the volatility and dynamics of the cash flows, and the reinvestment rates of those items. This sort of analysis, of course, requires a sound asset/liability reporting system. Importantly, we also need to have a handle on the liquidity position of the bank including the dynamics of cash flow going forward under different rate scenarios.
The interagency guidance on funding and liquidity risk management clarifies expectations, and two important points seem to stand out from that guidance. First is the statement that sound practice requires adequate levels of highly liquid marketable securities. The second is the need for pro-forma cash flow statements in order to monitor cash flow patterns under different scenarios. It is intuitive that static measures of liquidity represent mere snapshots at a particular moment in time. What is needed is a dynamic, forward-looking system of monitoring cash flow and stress-testing liquidity. An analogy used by Dr. Baker sums up the importance of prospective rather than historical views of liquidity:
“Liquidity can be compared to a dam that is almost empty just before the season of heavy rains and almost full before the onset of a drought. Therefore, banks must forecast the impact of future conditions on their liquidity, just as meteorologists forecast the weather.”
Fortunately, with the right tools any bank can produce useful reports designed to measure and monitor cash flow dynamics. This would include simulation analysis of multiple scenarios in order to show an institution’s projected exposures and potential funding shortfalls or gaps. Reporting should be made available to the board of directors along with strategies that address significant potential funding shortfalls (i.e., a contingency funding plan). As always, the depth of analysis and reporting should correspond with the complexity of the bank’s balance sheet.
Making Investment Decisions
Once we clearly understand the balance sheet profile and liquidity needs, we can then drill down to the investment portfolio and assess our strategic options there. Banks should invest only in high-grade credit quality instruments, something with government sponsorship at either the federal or municipal level. We take credit risk in the loan portfolio. The investment portfolio, as noted, should contain safe, marketable securities. When assessing individual bonds, we can then focus on the three critical variables: yield, cash flow, and market value or price sensitivity. The fact is, all of these variables are moving targets. Cash flows fluctuate because of the options risk attached to or embedded within bond structures themselves. The market value of individual bonds (and entire portfolios for that matter) will rise and fall in tandem with the variation in cash flows. All of these dynamics (cash flow, price sensitivity, and options risk) should be assessed for each bond to see whether or to what degree they fit into the needs and predispositions of the balance sheet. Ideally, we can identify bonds that are optimal and complimentary to the bank, given its unique characteristics in terms of interest rate risk exposures, tax considerations, and liquidity risk. In the final analysis, a bank’s bond portfolio should not be managed in a vacuum. Rather, the investment function should be viewed within the framework of the total system.
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