Tools for Managing Liquidity Risk

Lessons Learned on Liquidity Risk

The FDIC and other regulators continue to underscore the importance of sound liquidity risk management for financial institutions. The focus on liquidity has been building for some time as steady loan growth during the past several years has resulted in a decrease in short-term liquid assets and an increased reliance on wholesale funding sources. These are familiar patterns in the late phase of an economic cycle. In the wake of the 2008-09 financial crisis, for example, FDIC noted that disruptions in the credit and capital markets had exposed weaknesses in liquidity risk measurement and management systems. Among other things, specific mention was made of banks that relied on “liability-based” funding strategies or those that have “other complex liquidity risk exposures.” Those institutions were encouraged to use dynamic cash flow analysis to monitor their liquidity exposures and to have robust contingency funding plans. That remains good advice today for any who haven’t done so.

Funding the Bank: A Brief History

For generations, community banking was a process of gathering deposits from households and businesses that held excess cash and making loans to others who needed credit. A variety of changes took place in the early 1980s that were to have profound effects on the business of banking for years to come. Legislation removed intrastate banking restrictions and deregulated deposit rates. Competition among banks soared as banks were allowed to go outside of their geographic market to seek deposits. In the wake of those changes, bankers realized they would need to explore alternative sources for funding their banks. Today, both small and large banks regularly use wholesale sources and rate-sensitive deposits as part of their funding strategies.

Contingency Funding Plans (CFP)

Banks should develop a contingency funding plan if they do not currently have one. This is a plan that comports with the liquidity risk profile of the institution and lists potential liquidity events that could result in problems. These events could be market oriented and only indirectly related to the bank, or they may involve issues specific to the institutions, such as credit or asset quality concerns, falling below a well-capitalized position, unexpected asset growth, sudden loss of deposits or funding sources, or other negative liquidity developments. The ultimate effect of any single event should be taken into consideration, and the bank should game-plan alternative strategies in response.

Investments and Liquidity

Banks traditionally used the investment portfolio as a store of liquidity. This original purpose seemed to have faded somewhat as alternative sources of funding became available and widely used. Today, it may make sense for banks to revisit the role of the investment portfolio as a vehicle for managing liquidity. Proper identification of bonds and bond-types that provide reasonably consistent and predictable cash flow, as well as securities that are readily sold in the secondary market, is critical. The risk/reward relationship for securities should be viewed with an eye toward liquidity risk. When purchasing a bond or considering alternatives, portfolio managers should take a hard look at the cash flow uncertainty or optionality as well as the underlying price sensitivity.

Scenario Cash Flow Analysis

From a liquidity management standpoint, the ability to monitor the scenario dynamics of investment cash flows is extremely important. Projected cash flows under the existing rate environment are a necessary starting point, but must be supplemented by additional projections for different rate scenarios. We know portfolios that contain callable bonds and/or MBS will experience faster cash flows when rates fall, and slower cash flows when rates rise. This asymmetry of cash flows and the degree to which those cash flows are uncertain needs to be calculated and reflected in an analytic reporting model.

Liquidity risk management is obviously important in today’s environment from both a regulatory standpoint and from the perspective of prudent bank management. Having the right processes, tools, and management practices in place will help the bank maintain healthy performance and an optimal risk/reward profile.

The Baker Group is one of the nation’s largest independently owned securities firms specializing in investment portfolio management for community financial institutions.

Since 1979, we’ve helped our clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizes software and products developed by Baker’s Software Solutions* combined with the firm’s investment experience and advice.

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Jeffrey F. Caughron

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The Baker Group LP

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