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Bank Liquidity andBank Liquidity andWholesale Funding IIWholesale Funding IIBank Liquidity andBank Liquidity and
Wholesale Funding IIWholesale Funding II
Examination Guidance Examination Guidance and Proceduresand Procedures
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Examination Guidance and Procedures
Overview UBPR ratios Borrowings and Pledging Interest Rate Risk Capital and Earnings Examples
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RD Memo, Transmittal #2000-046
Issued August 22, 2000 In response to:
– Increase in FHLB membership– Increased complexity and short-term nature of
advances Discusses:
– Asset/liability management strategies that banks employ with the use of advances
– Framework for examining the effects of these strategies.
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Section 6.1 of the Manual of Examination Policies
Additional funding sources, such as: – Borrowings– Trust preferred securities– Asset securitization
Core versus non-core deposits Brokered and rate sensitive deposits Warning indicators for liquidity and contingency
planning Funding diversification versus cost Changes in UBPR ratio analysis
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RD Memo, Transmittal #2002-039
Issued August 28, 2002 FDIC does not discourage use of wholesale
funding sources when incorporated into well-managed funding program
Examiner comments/criticisms related to:– Degree of risk faced– Quality of bank management
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Supervisory Perspective
Risks associated with FHLB advance usage
Impact when managing:– Liquidity– IRR– Earnings– Capital
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Liquidity Implications
Historically - liquidity ratings were driven by balance sheet ratios
Now - possible for banks to operate with fewer liquid assets
Examiners – consider bank's access to wholesale funding sources
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Examination Guidance and Procedures
Overview UBPR ratios Borrowings and Pledging Interest Rate Risk Capital and Earnings Examples
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Advance Usage and UBPR Liquidity Ratios
Advances categorized as non-core funding Use can increase non-core funding
dependence ratios
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Caution
Be careful when determining institution's core funding sources.– Classified as core – may not be– Not classified as core – may be– Advances can increase the loans/deposits
ratio
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When Assessing Liquidity…
Traditional liquidity ratios may not present accurate picture
Follow existing exam guidance – consider:– UBPR ratios– Stability of FHLB advances– Institutions unused borrowing capacity
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Examination Guidance and Procedures
OverviewUBPR ratios Borrowings and Pledging Interest Rate Risk Capital and Earnings Examples
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Secured Borrowings – Disadvantages
Require collateral to be pledged Removes these assets as possible liquid
sources Concern is partially mitigated – FHLB
accepts assets not normally considered liquid
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Ramifications of FHLB Advances
Banks should understand ramifications FHLB can curtail advances if collateral
quality deteriorates below standards Banks should have backup plan Banks should understand risks associated
with Option-Advance Programs
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Funds Management Policies
Should discuss use of non-core funding sources
Limits and types should be outlined Discuss how these funds should be used Consistent with bank's strategic plan Board should understand risks/rewards
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Red Flag
Rapid growth funded by advances Strategy driven by consultant's
recommendation more than board/management strategic plan
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Examination Guidance and Procedures
OverviewUBPR ratiosBorrowings and Pledging Interest Rate Risk Capital and Earnings Examples
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FHLB Advances and IRR
Second area where FHLB advances should be evaluated
Advances can reduce or increase a bank's IRR exposure
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IRR Measurement System
Management measurement system Capture effect advances and assets funded
by advance has on the bank's IRR exposure
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Advance Containing Options
Pay special attention to these Rise in interest rates – FHLB probably
would exercise its option Examiners – determine if bank's IRR
measurement system accounts for terms of FHLB advances
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Examination Guidance and Procedures
OverviewUBPR ratiosBorrowings and PledgingInterest Rate Risk Capital and Earnings Examples
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Purchasing Earning Assets
Some banks use advances to purchase earning assets
May cause increased IRR and credit risk May cause a decline in the NIM and ROA Monitor this risk/reward tradeoff
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Advances and Growth Strategy
Advances used as part of growth strategy require controls
Examiners – determine if institution has controls in place
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Projections
Projections should be made for:– Cash flows– Profits– Balance sheet composition– Resulting increase in risk
Examiners – review this activity
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Examination Guidance and Procedures
OverviewUBPR ratiosBorrowings and PledgingInterest Rate RiskCapital and Earnings Examples
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Wholesale Funding Transaction
Jan. 15, 2004 – Bank obtained FHLB advance and purchased FNMA note
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Wholesale Funding Transaction (continued)
Funding– $10 Million FHLB advance at 2.95%
• 121 bp less than a traditional 5-year, fixed-rate advance
• 31 bp less than a traditional 1-year, fixed-rate advance
– 5-year /1-year option
Investment– $10 Million FNMA note at 4.11%
Matures on 1/15/2009
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Transaction Performance
How did this strategy work?
Date Note Advance Spread
1/2004 4.11% 2.95% 116 bp
On 2/15/2005 advance was called and replaced with a fixed rate, non-callable advance at 4.20% for a 3.75 year term.
2/2005 - Present
4.11% 4.20% (9 bp)
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Replacement Funding
New advance Spread on transaction changes
dramatically – is negative Initial low advance rate - attractive Many institutions do not consider
repercussions
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Risk Associated with Callable Advances
Option will be exercised to benefit FHLB Detriment to the borrowing institution Examiners may see this scenario
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Examiners – Consider These Questions
Does management understand characteristics/risks?
Is transaction consistent with bank's strategic plan?
Does transaction comply with bank's policy requirements?
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Also Consider…
Was management’s selection process of components carefully considered?
Prior to executing transaction – did management evaluate risk/reward tradeoffs?
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Finally, consider these questions…
Is the bank’s IRR measurement system capable of accurately modeling both the asset and liability components of the transaction?
What is the transaction’s effect on the bank’s overall IRR exposure?
What is the impact on the bank’s liquidity?
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Wholesale Funding Transaction
Proposed Transaction Investment
– $10 Million FNMA 5:0% CMO (Accretion Directed, TAC)
– Average Life: 5 years– Yield: 4:98%
Funding– $10 Million FHLB Amortizing Advance– Maturity: 5 years– Rate: 3.09%
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Wholesale Funding Transaction
Bank Balance Sheet: Before Transaction
Total Assets $100 Million Liabilities $90 Million
Capital $10 Million
Tier 1 Capital Ratio: 10%
Bank Balance Sheet: Before Transaction
Total Assets $110 Million Liabilities $100 Million
Capital $10 Million
Tier 1 Capital Ratio: 9.1%
Projected Spread: 1.89%
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Funds Management Policies
Leveraging with FHLB advances easily attained in large quantities allows for rapid growth
Banks need sound funds management policies
Growth should be planned and well-managed
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Questions Examiners Might Ask
Asset quality Economic conditions Overall risk profile
With the decline in the bank's capital ratio, is the bank's capital position expected to remain satisfactory when considering trends in:
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A Growing Source of Funding
Growth in traditional core deposit products lag increases in non-core funding
Wholesale funding – secondary source of support for community banks
Yet, this funding source is growing
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Depositor Behavior
Influenced by several factors Depositors more inclined to invest in
shorter-term, highly liquid deposit products Bank customers do not want to tie up
dollars for extended periods of time
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We Might Ask:
Are these funds actually 'core' deposits? How 'sticky' are these 'core' deposits?
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Higher Yields
Depositors investing funds longer-term utilizing higher yielding deposit products (i.e. brokered, jumbo CDs)
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Wholesale Funding Trend
Due to various factors – wholesale funding plays prominent role in banking strategies
Trend likely to continue
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In the next section…
Select the next section, Presentation Review, to continue.
