By Karl Nelson

With the ever present squeeze on net interest margins within our industry, many community bankers are looking for ideas that will help in retaining or, at least, slowing down this negative trend. As we all know, the “L” in “CAMELS” is a very key ingredient in managing a successful institution and making certain that liquidity is always present often defines the difference between success and failure. Many like to think that bad loans cause failure – in fact, they are often the major contributing factor, but the inability to fund the next dollar of activity is the actual last step in a failure. And, this is why we bankers are so careful with liquidity. But, more aggressive liquidity techniques can also create enhanced profitability.

Historically, most community bankers have used an Asset-Based liquidity model. In this model, we attempt to retain approximately 20% of our assets in highly liquid instruments. Often, this instrument is an investment in the Fed Funds market, but other liquid instruments such as treasury and/or agency securities are also used. This is asset-based liquidity and the clearest way to see this strategy is to examine the typical community bank balance sheet focusing on the Loan / Deposit ratio. Though this ratio has become less significant in measuring a bank’s liquidity position, it is still the most recognized method for judging this component. When we break down our industry and look at the three major groupings – banks with assets < $100 million, banks with assets of $100 million to $1 billion, and banks with assets exceeding $1 billion – this concept becomes very obvious. During the 2001 – 2007 timeframe, our smallest group reflected a Loan / Deposit ratio of between 72.4% and 75%. Our second group showed a ratio of 79.5% to 85.4% and our large group fluctuated between 92 and 95%. Clearly, the larger  the institution, the less concern for asset-based liquidity. It is also interesting to note that those banks in the two largest groups have been expanding in numbers while the smaller players have seen their numbers reduced by just over 1000 institutions during that period of time.

So, what are your options as a community bank? Many are discovering the profit benefits associated with liability-based liquidity techniques. Nothing fancy here – we simply mean that less of the balance sheet is earmarked for the investment portfolio and more of the assets are in the loan portfolio. The pure profit logic is inescapable in the yields that each one offers. In today’s competitive world, investing in the Fed Funds market will provide a yield just under the Fed Funds Target Rate (at this writing, this was 3.00%). If you are inclined to take on more interest rate risk, the mortgage-backed market can be much more interesting from a yield standpoint, but that yield will still be less than a good old prime-based loan (currently 6.00%). The math is simple – it just makes sense to put as much of your assets in good loans as possible so long as you have a good liquidity policy and practice. This is, of course, the issue in our community bank world – having this policy in place. But, even more important is the execution of the policy.

A good liability-based liquidity policy can provide enhanced earnings simply by the fact that you are investing more of your assets in higher yielding loans. But, be careful that you have the necessary ingredients for such a higher risk liquidity policy. Our friends in the regulatory arena have been very good about describing for us what this means and will be supportive of you so long as you document, report, and understand your policies. Liability-based liquidity does suggest a much more robust cash flow modeling than has been present in the past. Fortunately, none on this five year analysis – just take the next twelve months and lay out the monthly input and outflows to your balance sheet. Then, do some serious “shock” analysis – the more realistic the better. The point here is to understand what risks are present and what may become a problem in the next year. This gives you and your Board a clear idea of liquidity expectations for the next twelve months and points out where the problems might surface. Many of you are becoming familiar with the term “Contingency Funding Plan” or “CFP” as the examiners came through in 2007 and now into 2008. The Contingency Funding Plan has become a key ingredient to a well conceived Liquidity Policy and all of us should be aware of the need for such a plan. I think you will hear more about this in 2008 and it is a good idea to get started on yours right now.

Liability-based liquidity can lead to enhanced profits and can aid a community bank in its fight for net interest margin. But, do not make the mistake of executing such a policy without a sound plan. Another issue with liability-based liquidity is having good sources of wholesale funding and that will be the subject of our next column. Stay tuned for more…

<back to March 2008 Directors Digest>