Publications & Resources

November/December 2009
Focus: Directors Issues

 

Liquidity Risk Management: A Survival Strategy for the "Liquidity is King" Mantra 

By Brian Battle         

Banks nationwide continue to witness ongoing pressure to document sustainable liquidity during this time of global financial stress. From regulators to investors, a key question is whether an institution has sufficient liquidity. Perhaps, the six most common words from regulators these days are: Where is your Contingency Funding Plan (CFP)? More than ever, regulators are stressing the importance of liquidity risk management. 

Ever since the global margin call began in 2007 and was amplified in 2008, regulators have issued numerous comment letters stressing the importance of liquidity risk management. “Recent disruptions in the credit and capital markets have exposed weaknesses in liquidity risk measurement and management systems,” observed one FDIC letter (FIL-84-2008). “Some institutions have underestimated the difficulty of obtaining or retaining funding sources during times of financial stress,” cautioned another.   

More recently the Office of the Comptroller of the Currency warned bank management not to let earnings pressures outweigh the need for liquidity (OCC Bulletin 2009-15). “While portfolio yield is an important consideration, yield generation should not be the primary motivation when making investment decisions. Bank management should ensure that earnings pressures do not override liquidity needs when making decisions about the composition of the investment portfolio,” stated the OCC. This is a dramatic and explicit focus by the regulators on funding. With the days of automatically available and ever cheaper funding long gone, it’s time to take a look at some options.

One key but often-overlooked strategy to easing liquidity concerns is issuing longer-term brokered deposits. The most common bank strategy for wholesale funding is to borrow as short as possible to minimize the impact on quarterly net interest margin, and act as a synthetic floating rate funding mechanism. For example, more than 85% of wholesale brokered CDs mature in one year or less. But this strategy has historically left the issuing bank vulnerable if rates rise. It’s no secret that we are seeing extreme volatility in short-term rates. (See accompanying chart). In addition, a strategy of short-term borrowing creates an unmeasured cost/risk of losing access to the funding markets. Some banks might lose access to the market entirely either through a decline in individual bank credit-worthiness, an increase in home loan margin requirements or higher FDIC insurance costs. This invisible cost can be converted into a real expense and have potentially catastrophic consequences.

We believe that banks should consider using longer-term brokered CDs to (1) limit risk when interest rates rise and (2) reduce the risks associated with losing access to funding due to continued or even additional market turmoil.

Banks have resisted longer-term brokered CDs in the past due to regulatory bias against elevated levels of wholesale funding and perceived high costs. 

However, while this type of funding is marginally more expensive than other sources of funding, we suggest that the explicit benefits of long term core funding can outweigh the additional expense. We liken this strategy to the responsible act of buying insurance. You will always endure the cost of the insurance premium. However, the benefit is immeasurable whenever the insured event happens.

Moreover, if rates rise while deploying this strategy, your bank will be positioned advantageously.  If rates decline, this risk can be mitigated through careful structuring of the CDs themselves.

We have seen more banks turning to long-term brokered CDs during the past 18 months as a key way to establish durable, stable deposits and manage interest rate exposure.

In summary, institutions looking to establish stable deposits should first quantify the amount of short-term deposits (wholesale and retail) and then recognize the interest rate and replacement risk they pose. If there is an overdependence on short-term funding, either in-house or wholesale, consider executing a funding strategy to issue longer-term structured brokered CDs.

Our survival strategy takes a page from the Corporate Treasurer’s playbook that goes long on maturities for stable, predictable funding. For banks, this means utilizing longer-term structured CDs, a practice that accomplishes four critical goals:

  • Ensures stable, core funding during this liquidity crisis.

  • Ensures stable, core funding in the event of credit deterioration at your institution.

  • Is favorable to Federal Home Loan Bank funding because no collateral is required and no future haircut can occur through a margin call.

  • Allows the issuing bank to refinance if rates decline or excess liquidity is no longer needed.

Longer term, wholesale funding will slightly reduce net interest margin today, but the inevitable risks and invisible benefits have to be measured and managed for the long-term health of your financial institution.

Brian Battle, Vice President, is a Vice President at Performance Trust Capital Partners. He can be reached at 312-521-1651. For more information, go to www.performancetrust.com. This article is for general information only and does not represent any specific financial or legal advice for any individual institution.

Unauthorized reproduction of all or part of this material without the express written consent of the author is strictly prohibited. All rights reserved.