Publications & Resources

July/August 2009
Focus: Risk Management

Liquidity Management – An Evolving Perspective

By Pat Dorn

An Evolving Perspective

The funding and liquidity landscape has changed dramatically for banks over the last several years. The increased use of wholesale funding, including secured lines such as the FHLB and unsecured lines, such as brokered CDs and brokered money market deposits, has provided banks with the opportunity to leverage their balance sheets beyond historical norms. It has also provided greater flexibility in deposit pricing and interest rate risk management and greater diversity in funding and liquidity management.

The reviews, though, have not all been positive for these changes in funding and liquidity management. Some see the use of increased wholesale funding as the foundation for riskier lending practices in recent history. Others still consider the use of wholesale funding and its place in liquidity management as a volatile and expensive source. Increased loan losses and the resulting pressure on capital ratios, plus increased regulatory scrutiny, has put banks in a position where some of their funding sources are being limited or disappearing. The result is a constrained liquidity environment requiring increased and more proactive management by the bank and enhanced reporting, both internally and externally.

Current Regulatory Environment

The debate continues as to the root cause to blame for the current state of the banking industry. Current regulatory guidance points to a future where one of the potential causes, wholesale or brokered funding, will be monitored with more scrutiny. Recent guidance from the FDIC includes:

FIL – 84-2008 – Liquidity Risk Management
“The FDIC is issuing this guidance to highlight the importance of liquidity risk management at financial institutions.” The letter provides further guidance on the limits on brokered deposits, expectations for minimum capital levels depending upon risk, and contingency funding.

FIL – 5 – 2009 – Interest Rate Restrictions on Institutions That are Less Than Well-Capitalized - Notice of Proposed Rulemaking
“The proposal would redefine the ‘national rate’ as a simple average of deposit rates paid by U.S. depository institutions, thereby discontinuing the use of Treasury yields, which are currently well below average deposit rates – in the definition.” The proposal continues on to provide guidance under Part 337.6 on the rate of interest that an insured depository institution that is less than well-capitalized may pay.

FIL – 12-2009 – Deposit Insurance Assessments; Final Rule on Assessments; Amended FDIC Restoration Plan; Interim Rule on Emergency Special Assessment
“On February 27, 2009 the FDIC: (1) adopted a final rule modifying the risk-based assessment system and setting initial base assessment rates beginning April 1, 2009 at 12 to 45 basis points; (2) due to extraordinary circumstances, extended the period of the Restoration Plan to seven years; and (3) adopted an interim rule with request for comments imposing an emergency 20 basis point special assessment on June 30, 2009, which will be collected on September 30, 2009, and allowing the Board to impose possible additional assessments of up to 10 basis points thereafter to maintain public confidence in the Deposit Insurance Fund.”

FIL – 13-2009 – The Use of Volatile or Special Funding Sources by Financial Institutions That are in a Weakened Condition
“Directors and officers of financial institutions are responsible for overseeing their institutions’ operations in a safe and sound manner. Institutions rated 3, 4 or 5 are expected to limit balance sheet growth and take actions to improve their risk profile while they work to remedy their problems. Institutions rated 3, 4 or 5 that engage in material growth strategies, especially those that are funded with volatile liabilities or temporarily expanded FDIC insurance or liability guarantees, pose a significant risk to the insured deposit insurance fund and will be subject to heightened supervisory review and enforcement.”

Reducing Dependency

There are several factors that currently favor banks wanting to reduce their dependence on wholesale funding and in particular, brokered deposits:

Investment portfolios currently contain market gains making it economically advantageous to de-leverage this sector of the balance sheet, if the securities are not required for pledging purposes,
Money market mutual fund rates have trended below most FDIC insured bank deposit rates, making the transfer of personal savings back into bank deposits an attractive option,
Corporations are stockpiling cash and consumers are spending less and saving more,
Loan demand, both corporate and consumer, has slowed from the overheated pace of a couple of years ago
Lending standards have been tightened, further slowing the flow of credit

There also has been an increase in opportunities to diversify wholesale funding from brokered deposits into other sources of funding. These include:

Expanded criteria for acceptable collateral at both the FHLB and the Fed Reserve,
The ability to collateralize some municipal deposits with municipal securities instead of Agency debt,
CDARs
Internet CDs

All of these factors combined present individual institutions with an opportunity to:

Evaluate their current balance sheet position for potential opportunities to de-leverage with potential minimal income statement impact in 2009,
Replace wholesale or brokered deposits with increased deposits from money fund transfers, corporations holding more cash, and consumers saving more,
Diversify the types of wholesale funding being utilized beyond brokered deposits and the FHLB, and
Improve capital ratios

Put it in Writing

Beyond making changes to the balance sheet, it’s also an opportune time to review and potentially add a few enhancements to the Interest Rate Risk Management Policy.

The establishment of KPIs, or Key Performance Indicators, for liquidity provides an empirical and objective assessment of the bank’s liquidity position at ALCO and more frequently, if desired. Some of the key measures that can be used include, but are not limited to:

FHLB Advances/Assets
Brokered CDs/Assets
Total Basic Surplus/Total Assets
Core Basic Surplus/Total Assets

Also, a Contingency Funding Plan (CFP) within the Interest Rate Risk Management Policy should be established. A CFP should outline the steps to follow when there is a crisis for prioritizing and selecting the appropriate funding vehicles by availability and cost. The steps should be laid out in order of execution with the objective of providing liquidity at the least possible cost. Steps will range from accessing available fed funds lines, utilizing available FHLB advance lines, obtaining brokered deposits and CDARS where available, pledging of collateral for repurchase agreements, and ultimately, the potential sale of assets.

The current banking environment again reminds us of the need for a proactive approach to liquidity management. The product of that increased diligence overall will be a more sound banking industry capable of weathering future economic downturns

Pat Dorn is a consultant and vice president with M&I Capital Markets. He can be reached at 702-691-2210 or pat.dorn@micorp.com.