Publications & Resources

September/October 2010
Deposits & Liquidity

 

A Brief History of Liquidity Crises and the Effect of the “Interagency Policy Statement on Funding and Liquidity Risk Management” on Community Banks

By Richard Aubrey

Banking is an extraordinary business endeavor.  The very business of banks makes them naturally illiquid enterprises. They fund long term assets with short-term liabilities. Over the past decade large numbers of banks operated with loan-to-deposit ratios in excess of 100% and their entire investment portfolios leveraged. Cash flows of bank balance sheets are often indeterminate and in a crisis, completely unpredictable. Even long-term time deposits may be withdrawn (albeit with penalty) unless the banker wants to risk a complete loss of customer confidence. Without confidence, depositors and creditors flee. Most businesses, both for-profit and nonprofit, have more predictable cash flows. The Quaker Oats Company has a pretty good idea how many boxes of “Captain Crunch” they will sell every month and the related cash flow. The same cannot be said of banks.

The history of banks and money consists of a trail of crises such that a bank’s basic operating assumption should be that the next crisis is just around the corner. Since the earliest use of paper to transact commerce, beginning with cambium contract in the late twelfth century in Northern Italy, through the 1763 crisis in the market for “bills of exchange” following the Seven Years’ War, banks have endured periodic liquidity crises. The 20th century began with the Panic of 1907, followed by the Great Depression, the S&L crisis, the failure of Long Term Capital Management (1998), “Y2K” (1999), the attacks of 9/11, and finally the banking chaos of 2007-2010. Recent foreign crises impacted the U.S. banking system (Japan, 1986-2003; Asian 1997; Russian 1998; Argentine 1999; Greek, Spain, and Portugal 2010). All these events are just one long parade of crises that should have taught us something about liquidity management. The guidance contained in the March 2010 “Interagency Policy Statement on Funding and Liquidity Risk Management” should have already been the basic operating practice of every bank.      

As a starting point the Interagency Policy Statement provides a basic description of Liquidity: “Liquidity is a financial institution’s capacity to meet its cash and collateral obligations at a reasonable cost.” A principal tenet of banking is liquidity has a cost and during a crisis a potentially very dear cost. Additionally, the Statement defines liquidity risk as the: “Risk that an institution’s financial condition or safety and soundness is adversely affected by an inability, or perception of inability, to meet its obligations.” This brings to mind the disconcerting newspaper photographs of the lines of customers surrounding various Indy Mac branches.

Briefly, the Interagency Policy Statement on Funding and Liquidity Risk Management consists of eight sections:

  1. Corporate governance
    As with all bank operating policies (e.g. lending, interest rate risk, investments) the board is ultimately responsible for establishing the level of risk and the approval of strategy, policy, and procedures. Senior management is charged with ensuring that Board-approved liquidity strategies, policies, and procedures are properly executed.

  2. Appropriate strategies, policies, procedures, and limits
    Banks, in an effort to limit and control liquidity risk, need to document clear policies and procedures that reflect the bank’s risk tolerance. Policies should articulate a liquidity risk tolerance that is suitable for the business strategy of the bank considering its complexity, business mix, liquidity risk profile, and its role in the financial system.

  3. Comprehensive risk measurement, monitoring and reporting
    Every bank is expected to have a comprehensive method of forecasting cash flows from both on and off-balance sheet instruments using appropriate time intervals (short-term versus long-term). Assumptions are to be dynamic and reviewed periodically. Regulators are specifically looking for frequent stress testing with results driving the bank’s liquidity management and any corrective actions. Guidance is specific as to the management and monitoring of collateral positions with systems capable of providing the necessary information. There is an expectation that a bank will have in place a comprehensive and robust management reporting regimen covering all aspects of liquidity positions.

  4. Active management of intraday liquidity and collateral
    Regulators are very specific about the intraday monitoring of liquidity for those institutions involved with significant payment, settlement, and clearing activities. Senior management is expected to develop and implement a comprehensive intraday liquidity strategy.

  5. Diverse mix of existing and potential future funding sources
    Within the bank’s funding strategy it is expected that there will exist a diversification in the source and maturity of funding. Diversification of funding is to be executed within the budgeting and planning process, and utilize the appropriate short, medium, and long-term sources.

  6. Ample levels of highly liquid unimpaired assets
    The availability of unencumbered and highly liquid assets is an essential source of operating and contingent liquidity. The availability of such assets (highly marketable investment securities and cash) is considered a critical component of a bank’s ability to manage a liquidity crisis.

  7. Contingency funding plans
    It is surprising that the regulators have to even suggest that banks have a comprehensive contingency plan (CFP) considering the enormous effort that went into the preparation for Y2K. Nevertheless, each bank is required to have a formal plan that sets out the strategies for liquidity shortfall in emergency situations. Within the contingency funding plan there should be specific policies to manage a range of stress environments, lines of responsibility, and clear implementation and escalation procedures. The CFP should be routinely tested and updated.

  8. Internal controls
    As is expected with any critical function, regulators reiterate the importance of adequate internal controls that comprise the procedures, processes, reconciliations/certifications, and reviews necessary to provide assurance that the board approved policies are effectively executed.  Management is directed to supplement the controls with a regular independent review and evaluation of the liquidity risk management process.

In summary, with this guidance available in draft form since mid-2009, every bank should be well along in compliance with its directives. This is especially true having experienced the excruciating financial turmoil which has resulted in the failure of over 250 FDIC insured banks since 2007 and the collapse of many of the storied names on Wall Street.

Richard Aubrey is a consultant win RLR Management Consulting, Inc. He can be reached at richard.aubrey@rlrmgmt.com or 925-451-7406.

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