Financial Management Part II: Liquidity & You

By Chris Bledsoe, Banker’s Dashboard

What is liquidity and why is it such a big deal? Simply put, the amount of liquidity your bank reflects the institution’s ability to quickly convert assets into cash. This is critical because the bank needs cash to do everything from paying off brokered deposits (which are frequently used to fund loans) to paying out CDs at maturity. As you know, the recent credit crisis put a spotlight on liquidity risk and the regulatory agencies responded with specific guidance on policies and processes banks should follow to effectively manage this risk. This guidance also makes it clear that the board of directors is “ultimately” responsible for understanding and monitoring liquidity – and the regulators are watching this closely. Examiners want to see that your bank is proactively managing liquidity at all times and that you are playing a more active role in the process.

Here are the kinds of questions you need to be asking senior management to understand liquidity and ensure that the bank is maintaining, or taking the necessary steps to reach, its optimal liquidity position.

1. What is our current level of liquidity?  
   

2. What is our targeted level of liquidity and why? Keep in mind here that you don’t want too much liquidity because the bank won’t make money sitting on cash, but you must have enough to keep the regulators happy.
   

3. What’s our plan for meeting that targeted level? 
   

4. How are we measuring and managing liquidity and what steps are being taken to ensure that this discussion is part of our regular board routine? Typically, measuring and managing is done by the ALCO committee, but consider requesting a liquidity assessment as part of the board package. 
   

5. What’s our liquidity position now relative to where we think it’s headed? It’s important to look at the trend of where the bank has been and plans to go – because it’s all relative. For example, if you’ve got a 28 percent liquidity ratio, that doesn’t tell you much. If you can see that it’s been moving up from 12 to 15 to 17 percent and its now at 28 percent, but you are targeting 20 percent – that’s saying something. Then, you need to probe further to ensure that management is taking the right steps to effectively manage excess liquidity – which is likely costing the bank money.
   

6. Looking at where liquidity is headed raises other questions as well. What are our future cash flow needs? What is our forecasted liquidity and what’s driving it? For example, we know when timed deposits, such as CDs, will mature. One of the ways to manage liquidity is to decide how much of those higher-priced time deposits you will renew and how much the bank will let roll off. Of course, this isn’t always easy. No one wants to lose a customer. But if a CD is the only relationship your bank has with that customer, and you’ve got excess liquidity, it may be the best course.

If you find that your bank’s liquidity isn’t positioned well now, or you’d like a sure-fire way to ensure that it maintains a desirable ratio, the key is to grow core deposits. And, you can never have too much in the way of core deposits. For one, they’re a lot more stable than timed deposits; they’re significantly cheaper than timed deposits (which reduces cost of funds); and, core deposits increase the ultimate value of the bank.

The clincher here is that growing core deposits requires a strategic plan and top-down focused effort across the organization. You must work with senior management to put that plan in place and be sure to monitor the bank’s progress in executing it. (For some banks, their whole incentive plan is driven around increasing core deposits because everyone across the institution can be involved.) It’s also particularly important to remember that a big part of execution is having knowledge of your core deposit levels at each branch. Your bank needs to regularly track how each of its branches is performing and what factors impact their abilities to attract and retain core deposits. By knowing where strides are being made across the branch network and why, management can apply best practices to locations that may need coaching. This insight is vital for you as directors as well to be able to improve branch and overall performance – after all, a bank is only as good as the sum of its parts.

Liquidity is crucial to your bank’s survival and it will be a hot button for regulators into the foreseeable future – but what’s also significant from your perspective as a director is that it adds value to your bank. Therefore, by understanding liquidity and engaging with senior management to proactively manage it, you are meeting your objective to increase shareholder value.

 <back to August 2011 Directors Digest>