Managing Liquidity In Uncertain Times

By Steve Brown, Pacific Coast Bankers’ Bancshares

Liquidity is a funny thing for community bankers. Have too much and profit can be reduced or interest rate risk can increase. Have too little and the situation can be even worse, as recent conditions demonstrate.

Lately, bankers have been asking themselves whether it is possible to have too much liquidity. The market has been gyrating wildly and major companies have literally disappeared overnight as they have run out of liquidity. Community bankers simply do not have the nationwide branch network of a large national bank or access to international funding, so by definition, even more liquidity must be maintained.

As with anything, too much liquidity isn’t ideal. So what is the proper balance? Our advice is to focus a couple of easy things to get started, but remain consistent over time to balance risk and reward.

The $1 Billion Threshold
For starters, community banks with assets below $1 billion should maintain around 20% to 25% of total assets in liquid securities. Doing so provides ample cash flow opportunity (to reinvest or pay down more expensive borrowing), a reasonable return and flexibility. To remain liquid, banks should monitor cashflows, understand prepayments and readjust projections to shifting market conditions. Banks that focus on bullet/callable agencies or agency-guaranteed mortgage backed securities (with a duration of around 2 to 4) strike a reasonable balance between liquidity and performance.

Next, bankers should refocus efforts on measuring the performance in the loan portfolio. No, we are not referring to credit, but rather to liquidity. Therefore, we suggest bankers focus on getting a solid handle on prepayments and cash flow to maintain liquidity levels deemed appropriate by the board of directors.

The Importance of Stress Testing
Stress testing cashflows to better understand repayments under varying scenarios is a good start, but we also suggest modifying “what-if” scenarios to take into account changing market conditions. Bankers who can accurately predict 90% or more of their monthly cash flow are doing well in general terms, but keep in mind that maintaining accuracy over time is even more important. Periodically “back-testing” assumptions against actual results and then drilling in deeper to understand where differences are coming from is an easy way to modify going forward.

There are many things community bankers can do to better understand liquidity. However, in this market, there is no substitute for common sense. So if your models are still reducing interest rates by 300bp in a market where that is simply not possible, maybe it is time to reevaluate key assumptions.

Right now, having more liquidity is probably not a bad thing, but having a balanced amount is probably better.

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