Managing Interest Rate Risk (IRR) and Liquidity Risk in ... · (IRR) and Liquidity Risk in Differing Cycles ... Funds Transfer Pricing (FTP) ... a cost of funds “window”is

July 2015

Managing Interest Rate Risk (IRR) and Liquidity Risk in

Differing Cycles

Charlie Christy

South Carolina Bankers School

2July 2015

Class Dynamics & Ground Rules

• Personal objectives and expectations of this class

• Ground rules Expect class participation - learn from each other

Take advantage of this time - ask questions

There is no perfect answer - each bank and situation is different

Respect others while they are speaking

• If not covered in class - come see me or contact me [email protected]

810-869-5740 (c) or 843-341-9950 (w)

3July 2015

Class Agenda and Objectives

• Current Economic and Banking Environment/Events and their Impact on Banks

• What Exactly is Risk?

• Regulatory Perspective

• Asset/Liability Management Process

• Sample ALCO Reports Incorporating Best Practices

• Bank Liquidity

• When you are in Challenging Times or in a Crisis

• Mistakes Banks and Liquidity Managers Make

• Appendix Additional IRR and Liquidity Risk Information for your

Reading Pleasure

4July 2015

Introduction – Key Questions

• Excess Liquidity? How can you tell?

• Will rates increase? Impact to Deposit Rates?

• Stagnate or High quality loan demand?

• Competitors softening structures and lowering price

• Securities at all-time low yields and high premiums During the Crisis, did your bank increase its Securities

Portfolio?

Did you chase rate by going longer with securities portfolio What is the Risk in this Strategy?

• Any room left to cut costs?

• Have any of you seen any major changes to your ALCO process and/or Board Oversight?

July 2015 5

Net Interest Margins Peaked Early in 2002

Source: FDIC QBP

What are the

Key Drivers

for the

Decline?

Huge Level of Lost

Revenue and Capital

July 2015 6

Historical Treasury Yield Curves

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

30 Day 90 Day 6 Month 1 Year 2 Year 5 Year 10 Year 30 Year

5/23/08

July 2015 7

From Normal to Flat

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%


6/03/03

5/27/05

5/05/04

July 2015 8

Flat to Inverted and then to Lower Short-Term

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%


5/23/08

5/26/06

6/07/07

12/31/07

July 2015 9

Crisis – 6 Years of Low Rates

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%


5/23/08

July 2015 10

Periods of Sustained Fed TighteningWhat is in our Future

Cycle Number of Cumulative Beginning Ending

Duration Prime Rate Change Prime Prime

Start Date End Date (months) Increases in Rates Rate Rate

1960's

Dec-65 Aug-66 9 4 150 4.50% 6.00%

Dec-68 Jun-69 7 5 225 6.25% 8.50%

1970's

Feb-72 Oct-73 20 22 550 4.50% 10.00%

Mar-74 Jul-74 5 13 325 8.75% 12.00%

Jul-75 Sep-75 3 4 100 7.00% 8.00%

May-77 Dec-78 19 21 500 6.75% 11.75%

Jul-79 Dec-79 6 14 425 11.50% 15.75%

1980's

Feb-80 Apr-80 3 9 475 15.25% 20.00%

Aug-80 Dec-80 5 18 1050 11.00% 21.50%

Apr-81 May-81 2 6 350 17.00% 20.50%

Aug-83 Jun-84 11 5 250 10.50% 13.00%

Apr-87 Oct-87 7 5 175 7.50% 9.25%

May-88 Feb-89 9 6 300 8.50% 11.50%

1990's

Mar-94 Feb-95 11 6 300 6.00% 9.00%

Jun-99 May-00 11 6 175 7.75% 9.50%

2000's

May-04 Jun-06 24 17 425 4.00% 8.25%

July 2015 11

Trends in Core Deposits - Industry wideThis is why the regulators are concerned about liquidity

12July 2015

Imperatives for BankersIn a Rising Rate Environment

• Know your customer and know who is rate sensitive Reprice without moving the whole book

Utilize regional pricing strategies

• Enable segment and even customer targeted pricing

• Be prepared with a set of flexible plans that are responsive to differing scenarios Protect your liquidity and do it in a profitable way

• Execute better by testing now Across various regions, channels, and customer groups

• Improve your online capability as that will be where 60% of your customers will look first for better rates

13July 2015

Is it Time to…

• Take on new fixed rate debt and lock in low rates?

• Increase CD rates and lock in longer term rates at these low levels?

• Book long-term fixed rate loans to attract new borrowers?

• Since Residential loans have some demand, should we go ahead and book more on the balance sheet?

• Should we take all of our securities portfolio gains – if they exist?

• NPLs are down so should we lower our LLR and reduce provision expense?

• Should we sell our branches and move to more of a mobile/digital banking environment?

July 2015 14

Definitions

and

Fundamentals

15July 2015

Key Concepts and Definitions

ALCO

• (Asset/Liability Committee) responsible for managing assets and liabilities, primarily the institution’s interest rate risk

Duration

• Indicates the approximate price sensitivity (when will the instrument reprice) of a loan, investment, or deposit. Duration analysis compares the duration of the assets to the duration of the liabilities. If they are the same, then the bank is balanced/matched and immune to market rate changes.

Interest rate risk

• The risk that a change in market rates will affect a financial institution's income and the market value of its assets and liabilities.

Liquidity

• Institution’s ability to meet its needs for cash to fund loan and deposit outflows.

Marginal effect

• The incremental effect on income or expense caused by a pricing change to a product. Change in income or expense divided by the change in balances.

Asset/Liability Sensitivity

• Either assets or liabilities are repricing faster than the other. Asset sensitive (+) is where assets are repricing faster than liabilities. Liability sensitive (-) is where liabilities are repricing faster than assets.

16July 2015

Key Concepts and Definitions

Option adjusted spread

• Captures the value of options embedded in financial instruments even when they are not affecting cash flows.

Prepayment/Option risk

• This is where a customer has the ability to prepay loans at their option without penalty. This creates uncertainty in the amount and timing of principal and interest cash flows of a loan. Difficult to calculate since it represents the customer’s propensity to prepay.

Securitization

• The conversion of loans into a security. Accomplished by underwriting loans to secondary market guidelines. Delivered to the market for either securities or cash (helps with liquidity) and creates gain accounting recognition in most cases.

Price elasticity

• Measures how much consumers respond to price changes. Not linear. Products that have good substitutes have a higher elasticity of demand.

ROA

• Return on Assets - measures how efficiently the bank is using its assets to produce net income

ROE

• Return on Equity - measures how effectively a bank is using stockholder capital to produce income

17July 2015

Key Concepts and DefinitionsFunds Transfer Pricing (FTP)

FTP addresses the issue of how to provide a funding charge for assets and a funding credit for liabilities. In a simple sense, a cost of funds “window” is

hypothetically created for the bank and lenders borrow from the window and funds gatherers sell to the window. The window buys and sells according to

duration and matches the product to minimize interest rate risk.

Treasury then manages interest rate from an overall perspective and the rest of the bank doesn’t

have to worry about their position - in most cases.

Lock at the date of loan or deposit origination and remain

unchanged through the life of the loan.

Deposits may change according to movements in core deposit

assumptions

Components of FTP

Base funds transfer pricing rate (SWAP curve, brokered

CDs, etc.)

Overnight funds -

midpoint of bid-ask spread on Fed Funds

< 1 Year - a market

based index

> 1 Year -LIBOR swap

rates

Liquidity Premium - intended to account for the cost of holding funds to support assets for the estimated lives of those assets. Vary based on

the maturities for the underlying instruments.

May also include basis risk due created by using the LIBOR curve with

products that follow another index.

18July 2015

What is Risk?

• Risk is the possibility that an uncertain outcome or event might have and undesirable consequence

• Banks, as financial intermediaries, are in the business of managing risk Rent money from depositors – who want it back on demand

Then lend or invest that money in a variety of assets with maturities as long as 30 years Creates credit risk – has to repay depositors even if loan defaults

Difference in maturities (deposits collected and money lent) exposes the bank to liquidity risk

Accepts IRR - timing and size of changes in rates they receive rarely match the timing and size of rate changes in bank liabilities

• Credit, liquidity, and interest rate risk Inherent in the core economic function of Banks

July 2015 19

Types of Risk

Credit Risk

• Borrower fails to perform on an obligation

• Also reduces value of equity and debt securities

Liquidity Risk

• Not enough cash will be generated from either assets or liabilities to meet deposit withdrawals or contractual loan fundings

• Mortgage pipeline, internet CD maturities, etc.

Market Risk (IRR)

• Changes in prevailing rates will adversely affect assets, liabilities, capital, income, and/or expense at different times and in different amounts

• Reduction in earnings due to changes in rates

Operational Risk

• Errors made in the course of conducting business – results in losses

Legal Risk

• Unenforceable contracts, lawsuits, adverse judgments

Reputation Risk

• Negative publicity on the Bank’s business practices, whether true or not, cause a decline in the customer base, costly litigation, or revenue reductions

20July 2015

Interest Rate Risk and Its ComponentsFour Fundamental Risks - Primary

• Repricing risk Risk of rates moving up or down

Duration, Gap, or mismatched maturities

• Basis risk Imperfect correlation between coupon-rate changes for assets,

liabilities, and off-balance sheet instruments LIBOR-based deposit rates change differently than prime-based loan rates

• Yield curve risk Risk of ST Rates changing by more/less than LT Rates

Repricing mismatches can also expose a bank to changes in the slope and shape of the yield curve

• Option risk Risk that rate changes prompt changes in amount/maturity of

instruments

When an instrument’s cash flow timing can change or amount can change because the holder has the right (not the obligation) to buy, sell, or alter the cash flow

21July 2015

Interest Rate Risk and Its ComponentsFour Secondary Risks

• Secondary Risks Risk that errors in the IRR Mgt. process results in less than optimal

decision

• Measurement Risk that suboptimal decisions resulting from incorrectly measuring

the amount of IRR Model – incorrect due to inaccurate IRR models

Raw Data – entering incorrect data in the IRR models

Assumption – incorrect assumptions in the IRR models

• Reporting Incorrect reporting of IRR

• People Insufficient skills and expertise in the employees responsible

• Decision Process Untimely, slowly executed, and/or improperly communicated

decisions that fail to use all the available information

July 2015

Regulatory Perspective

23

1) Use an IRR measurement tool that captures the types of risks you have on your balance sheet

2) The Board has the ultimate responsibility for the risk undertaken

3) Measure IRR from a short-term and long-term perspective

4) Be sure you understand the underlying assumptions and analytics used by the model

5) Earnings at risk should be measured using a 1-yr, 2-yr, 5-yr, and/or 7-yr timeframe

6) Earnings simulation can either be “Static” or “Dynamic”

7) Economic value-based models should be used to broaden the assessment of IRR exposure

8) Just running a +/- 200bp stress-test is not sufficient

9) The regulators recognize that a 100, 200, and 300 bp shock is probably sufficient for most banks

10) You should pay attention to key assumptions like prepayment speeds and core-deposit sensitivity

11) Back test the model and learn how to us the model better

12) Have someone independently review your modeling process

July 2015

Advisory on Interest Rate Risk Mgt.This is not the reason we evaluate and understand IRR

24July 2015

Liquidity and IRR Changes to Date

• Sources and Uses Used to project out a few months

Today it needs to be a monthly process projecting out a couple of years Embedded options included

Changes in flow between assets and liabilities – fully understood

Stress scenarios for liquidity contingency funding

• Liquidity Contingency Funding Plans Used to be reserved for the most troubled banks and only if there is a “run” on

the bank

• Non-Parallel Shifts Used to be only for the big banks

Now we do ramps, twists, curves, and shocks

• Earnings Horizon Projections Used to be a budget and periodic estimates

Conducted monthly or quarterly with a next 24 mos. view

• Funding Concentrations – especially wholesale Know available sources of funds by provider and the amount

Reviewed by ALCO every meeting with discussion on which sources that could disappear

25July 2015

Liquidity and IRR Changes to Date

• Stress Testing “Shocks” are out, “Stress” is in

Most of us have no clue how to really do it

• Model Validation Conducted at least once a year

Has created a new cottage industry

• Off-Balance Sheet Position Methodology With Basel III – caps, floors, SWAPs, and other derivatives

• Implied Floors Floors will now impact our future so that puts “caps” in play

As rates rise borrowers and depositors will push back

• Decay Rates Deposit decay – changed dramatically over the past few years

Likely to change again as disintermediation will enter the picture

26July 2015

Bottom Line for Community BanksOCC Comments, Trickle-Down, Field Officer Perspective

• Must have an Effective Process to:

Asses its capital adequacy to risk

Plan for maintaining appropriate capital levels

• What do we get from a Stress Testing Process?

Better definition of our Risk Appetite

Loan Portfolio, Liquidity, Investment Portfolio, Wholesale Funding

Mix, Operational Risk are all in alignment with the Capital Plan

Better Risk Monitoring

Identifies key risks and quantifies the impact

Creates a “Forum” or a “Debate” within the Bank on risks,

assumptions, action plans, and trigger points

A Process that identifies key vulnerabilities and potential

capital and earnings exposure

27July 2015

How Do We Formulate our Approach to Stress Testing?

• Look at all your Risks How do you evaluate them today and how do you stress

them?

• If you don’t then develop this evaluation into your monthly/quarterly process Sets the tone in the organization

Drives better aligned expectations into your culture

Allows for learning events that improve assumptions and analysis

Teaches Middle Mgt how to run a “Best Practice” business

Creates the Forum where “What If” questions are asked

Institutionalizes Risk Management into the DNA of your organization

July 2015 28

What are the Key Components?The Periodic Stress Testing Process

Process and Governance

•Roles and responsibilities fully defined

•Risk appetite, how we monitor, how we evaluate

•Senior Mgt and Board involvement (process and review)

Scenario Definition

•Typically run quarterly but at least annually

•Formalized to create ownership and to generate multiple scenarios

•Has adequate levels of severity with 3-5 scenarios (base and alternative stress sensitivities)

•2 year quarterly forecasts

Credit Forecasting

•Requires appropriate level of granularity to capture different product behavior

•Choose the spectrum you can manage (Consumer/Commercial)

oTop-down macro approach

Fed data series, regressions, simple multipliers

oSimple transition matrix approach

Use historical roll-rate data

oECAP (Merton model)

oMacro-enhanced roll-rate approach

oConditional transition approach

oConditional roll-rate approach

oBottoms-up loan level approach

Pre-Tax Pre-Provision

Profit (PTPP)

•Balance sheet mix and dynamics

•Utilize your Budgeting and ALM processes

•Create a rolling 24 month forecast updated quarterly

•Focus on ALM model and PTPP Components

•Base Case = Business Plan

Articulate Other Risks

•Accounting, fair value, bond portfolio, off-balance sheet impact

•Operational, fiduciary, contract, compliance, etc. impact

•Market risk such as liquidity (Bank and Holding Company), IRR/VaR, pricing impact

•Reputational, business cycles, local economic environment impact

Capital Assessment

and Management

•Capital position forecast for all ratios by quarter

•Capital actions by priority

oDividends and share repurchase

oEmployee incentives

oNon-common equity issues/redemptions

oOther contingencies

29July 2015

So What do we Have?At Least a Beginning Framework

• We have existing processes we can Lever and Enhance ALCO and Monthly Reporting

Credit Reporting, Loan Review, Credit Administration

Annual Budgets

Strategic Plans

Risk “Heat Sheet” and Compliance Reviews

Internal and External Audits

System of internal controls

Hopefully a Capital Plan

Market and geographic studies (RMA, Moody’s, etc)

• Just make sure that what you have is as sophisticated as the risk and complexity of your bank If not, then enhance your Stress Testing Process to meet that

standard – at least on an annual basis

July 2015

The Asset/Liability Management

Process

31July 2015

Asset/Liability Committee - ALCO

• Asset/Liability Process Dedicated to the analysis of balance sheet data to define and

manage interest rate and liquidity risk

• Key Issues for the Committee Interest rate risk evaluation and rate risk tolerance Liquidity and Capital management Product pricing and design Risk management and contingency planning Can identify strengths and weaknesses in the balance sheet and

target areas where changes should be made

• Develops Key Strategies to meet your Target balance sheet Retail vs. Wholesale strategies Impacts your pricing, selling, borrowing, even incentives,…

32July 2015

How can ALCO be More Effective?

• Become a profit oriented, action-biased

function

Asset and Liability pricing

Peer and performance analysis

Annual profit planning and strategic planning

• Make your ALCO the key catalyst for profit

enhancement

Where else in the bank is this done?

Its the best way to focus the bank

Drives discipline and best execution

33July 2015

Asset/Liability Management (ALM)Coordinated Mgt. of all the Financial Risks Inherent in the Business of Banking

• ALM – process of balancing the management of separate types of financial risk to achieve desired objectives Operate within prudent risk limits

• Coordinated Mgt. that should encompass Cash, loans, investments, fixed assets, deposits, ST/LT Borrowings,

capital, off-balance sheet commitment

Pricing, Net Interest Margin, Balance Sheet Monitoring

Interest Rate Risk Short term - Risk to Earnings (EAR)

• Risk to margin, net interest income (NII), and net income

• Includes base-runoff cash-flows and new business projections

Long term - Risk to Value (VaR) or Economic Value of Equity (EVE)

Liquidity

Profitability, performance, budget, and funds transfer pricing (FTP)

Certain aspects of credit, operational, legal, and reputational risks

• ALM is the “Huddle” that brings all business activities together into an overall picture of Balance sheet strength and weakness

July 2015 34

Let’s Define What We are Trying to doThe Financial Management Process

Tactical

Long Range Outlook

Asset/Liability Mgt.

Budgeting Process

Org. Profitability

Product Profitability

Customer Profitability

Strategic Where are we going?

How will we get there?

How are we doing?

Performance

Measurement

Tools

Source: AICPA conference with ProfitStars

35

• Margin What are we doing to mitigate

compression? Do we understand the added risk

to combat the margin compression?

• Interest Rate Risk What happens if rates rise? Do I believe the ALCO results? Have we factored in deposit

outflow coupled with stronger loan demand if rates rise?

• Capital What happens to TCE and our

TBV if rates rise? Have we explored hedging

against that potential impact?

July 2015

Balance Sheet ManagementAreas of Focus

Capital

Earnings

Balance Sheet

Interest Rate Risk

July 2015 36

Risk Management and Reporting

Common Interest Rate Measurement Techniques

Short-Term Measures

Static GapEarnings-at-Risk (EAR)

Should quantify the potential impact to earnings over a 12-24 month horizon

Long-Term Measures

Economic Value of

Equity (EVE)

Long-Term Earnings-at-

Risk

Could include long-term net income

simulations up to 5 years

37July 2015

Methods for Measuring IRRDiffering Models Utilized

• GAP analysis models Difference between the amount of interest-sensitive assets

and interest-sensitive liabilities that will reprice

On a cumulative basis during a given time horizon

Negative GAP = amount of liabilities repricing exceeds the amount of assets repricing

Decreases net interest income in a rising rate environment

Relatively simple to prepare and understand

Limited – cannot measure the effects of embedded options, yield curve twists, and basis risk

Should not be the primary tool for assessing IRR

• Economic Value of Equity Models EVE models reflect the NPV of the balance sheet cash flows

Insights into the longer-term IRR

38July 2015

Methods for Measuring IRRNet Interest Income and Earnings Simulation Models

• What does it Do? Measure the effects interest rate changes have on interest income

and/or net income

If properly calibrated this can capture the 4 types of IRR

Has more utilities than other models

Utilized as the primary tool to measure, manage, and control IRR exposure

• Best Practice Dynamic balance sheet derived from forecasts of future business

Do sensitivity analyses to key model assumptions

Large number of rate scenarios

Regular model validation

Critical assumptions Static vs. dynamic balance sheet

Flat vs. forward curve

Static (constant spreads) vs. dynamic prepayment functions

39July 2015

NII Simulation Model

• Limitations Short term in nature – common practice is 1-2 years (next 12

mos + next 12 after that)

Misses impact of options that are beyond the model horizon

Longer term (5-7 years) are recommended by regulators, but become very assumption driven and require lots of modeling skills and information

Ignores change in value of mark to market instruments (trading book, hedging portfolio)

• Large institutions Now are using more probability based yield curve evolution

Not a single path rate scenario

Utilizes a stochastic yield curve to derive a range of earnings estimates

• Much more granular

July 2015 40

Mismatch or Gap Profits

Time to Maturity

Inte

rest

Rate

s

Average Term

for Assets

Gap or

Mismatch

Average Term for

Deposits and

Borrowings

Average Cost

of Liabilities

Average Return

from Assets

Net Interest Spread

Source: Leonard Matz A/L Training

July 2015 41

Rate Sensitivity Simulations

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%


200bp Shock

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%


Twist

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%


Twist

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%


Twist

Chart I Chart II

Chart IIIChart IV

July 2015 42

Dynamics of Interest Rate ChangesLiquidity Risk and IRR

Steady State Rates Fall Rates Rise

What Happens when Rates Fall?

Liquidity improves with the addition of

“core” deposits. Interest rate risk is

increased as long-term investments are

funded with rate-sensitive deposit growth

What Happens when Rates Rise?

Liquidity declines as bank is more

dependent on borrowings to fund

balance sheet. This increases interest

rate risk even further if borrowings are

short-term

Source: Leonard Matz A/L Training

July 2015 43

Balance Sheet ImpactEconomic Value of Equity

July 2015

Sample ALCO Reports

Incorporating Best Practices

July 2015 45

Interest Rate Risk Dashboard

July 2015 46

Interest Rate Risk Dashboard

July 2015 47

IRR Sensitivity AnalysisDynamic vs. Static

July 2015 48

Equity Value at Risk (EVE)

July 2015 49

Actual & Projected Net Interest Income

July 2015 50

NIM Walkforward

July 2015 51

Benchmark PricingWhen we first started tracking benchmark rates

July 2015 52

Benchmark PricingAfter we showed the Retail Delivery Team the Missed Earnings

Note: There will always be a

difference in the “hot zone” due

to competition and market forces

July 2015 53

Investment Portfolio Impact on CapitalPrepared Monthly by your Fixed Income Advisors

July 2015 54

What Happens if Rates Rise?Monthly Process Already Provides IRR Stress Analysis

July

2013

54

55July 2015

IRR ManagementKey Considerations of Management

• No single measure of interest rate risk is totally accurate Keep a profound sense of skepticism concerning accuracy

• Interest rate risk exists (lurks) in more places than the Bank’s NIM Non-interest income, NIE, and credit risk are interrelated

• Process is the key – not the tools Impossible to forecast rates so run many scenarios

Deficiencies in the rate risk measurement systems

Management: How prudent is risk measured?

How often is it measured?

What actions are undertaken to control it?

How rigorous and timely are those actions?

View it all as a dynamic process – participation from many

56July 2015

IRR ManagementKey Considerations of Management

• The size of IRR exposure may be far less important than the Bank’s capability to react to adverse changes Sources of the exposure

Bank’s ability to offset that exposure

Time frame in which the exposure may be offset

“Cushion” of capital or earnings stream available to absorb any adverse consequences

• Conservatism is not the same as a bias toward overestimating Liability sensitivity Encouraged by regulators

Can create and encourage inappropriate risk mgt. actions

• Interest rate risk cannot be considered in isolation Rate, credit, and liquidity risk along with capital planning and

balance sheet management are all intertwined

July 2015

Bank Liquidity

58July 2015

Definition of Bank Liquidity and RiskVery Complex - No Single Metric to Reflect the Risk

• Liquidity A financial institution’s capacity to meet its cash and collateral

obligations - at a reasonable cost

Adequate levels of liquidity is having the capability to meet both expected and unexpected cash flows and collateral needs

Liquidity for a bank is its ability to raise cash quickly (within 30 days), without principal loss and at a reasonable cost

• Liquidity Risk Risk for a bank being unable to meets its obligations as they come

due Insufficient liquid asset,

Inability to liquidate assets, or

Inability to obtain adequate funding

Comprises both funding liquidity risk and market liquidity risk

59

Asset Related

• Insufficient availability of collateral

• Disruption in payment or settlement system

• Increased collateral requirements due to market risk losses, ratings triggers, or asymmetric documentation

• Inadequacy of a firm’s infrastructure to conduct securitization transaction

• Reduced liquidity of outright market for securities

• Too large a trading position relative to market volume, open interest, and number of market makers

• Failure of specialist liquidity providers in niche markets

• Unwillingness of counterparties to take settlement risk on collateral transfer across time zones

• Spurious diversification, while portfolios might be diversified strategies may be correlated across counterparties

• Lack of demonstrable liquidity due to bespoke nature of transaction

July 2015

Liquidity Risk Arises From Many Sources

Liability Related

• Accelerated withdrawal of relationship based and transactional deposits from bank and dealers

• Lack of competitive deposit strategy and products

• More rapid loan growth than deposit

• Loss of access to unsecured wholesale funding or extreme increase in cost

• Material dependence on wholesale short and long term unsecured funding

• Failure of major provider of unsecured funds

• Concentration of wholesale funding sources

• Reduction in the availability of money market lines available to the bank

• Reduction in ability to raise term money

• Reliance on credit dependent sources of secured funding and availability of lines

• Restricted access to secured funding markets

• Reliance on synthetic funding

• Technology risk related to funding

• Rating downgrade

July 2015 60

Liquidity Risk is Intertwined throughout the Bank

60

Market

Price Risk•Interest Rate

Risk

•Price Risk

•Option Risk

Credit Risk•Lending Risk

•Counterparty

Risk

•Issuer Risk

Event Risk•Legal Risk

•Political Risk

•Country RiskBusiness

Risk•Strategic Risk

•Reputational

Risk

Operational

Risk•Inadequate

Organizational

structures

•Incorrect Data

•Inadequate

Models

Customer

Risk•Call Risk

•Forward Risk

•Behavioral

Risk

Liquidity

Risk

61July 2015

Why Worry About Liquidity Risk?

• Uncertainty exists as a bank’s funding is affected by external events and other customer behavior Liquidity shortfalls can have system-wide repercussions

• Must develop the tools that: Are Tactical

Intraday and short-term to maintain the solvency of the bank

Are Structural Medium and long-term, measuring the dependence on depositors,

financial institutions, hedging of investments, hedging credits, and liquidity vulnerability

Are Contingent Stress testing, sensitivity analysis, ratios, etc.

• The financial markets are too complex for the average community banker So we need to know what we are doing

Don’t always trust your fixed income advisors

62July 2015

Stress-Test Your Funding Needs and Availability

• Recognize the interdependencies between liquidity, IRR, and loan credit quality positions ALLL model credit assessments in ALM model

ALM model cash flows employed in liquidity position model

Common data/inputs/behavior assumptions across all models is a “Best Practice”

• You already do this for IRR and EVE

• Add to the varying interest rate environments you use for IRR and EVE the ability to assess Cash Flows

Estimated Market Value Changes

July 2015 63

“Periodic” Liquidity Measures Volatile Funds Ratio

Volatile Funds 05/11/15 06/09/15 06/09/15 06/09/15

100% of Federal Funds Purchased and Repos 3,129$ 4,707$ 4,707$ 4,707$

100% FHLB advances payable in 90 days 20,000 20,000 20,000 20,000

20% of Non-Public Funds Single Maturity Jumbo CDs 300 301 25% 376 50% 752

20% of Retail time deposits maturing in 90 days 1,496 1,468 25% 1,835 40% 2,937

40% of Retail Internet time deposits maturing in 90 days 851 2,557 45% 2,877 60% 3,836

8% of Non-Maturity deposits - Top 50 Customers 7,168 7,870 12% 11,805 15% 14,757

5% of Non-Maturity deposits - Non-Public 12,828 13,325 8% 21,320 10% 26,650

Total Net Volatile Funds 45,772$ 50,228$ 62,920$ 73,638$

Total Assets 414,050 431,965 Red 431,965 431,965

Volatile funds as a % of Total Assets 11.05% 11.63% >20% 14.57% 17.05%

Volatile funds as a % of Total Deposits 14.79% 15.46% 19.37% 22.67%

12,692$ 23,409$

Volatile Funds Coverage

Fed Funds sold 410$ 410$ 410$ 410$

Hypothetica

l Fed Funds

Decrease (5,000)$ (10,000)$

Short-term investments (callable or mature in 90 days) - - - -

Cash surplus (deposits with other banks + cash, non-int. bearing) 13,597 10,744 10,744 10,744

Assets Pledged for Fed Funds Line or FHLB 13,750 17,000 17,000 17,000

Other MBS available to pledge to the Fed or the FHLB 24,822 20,712 20,712 20,712

FHLB Collateral Recapture for Advances 20,000 20,000 Already at 90% 80% 16,000 70% 14,000

HME Loans HFS 40,798 56,173 80% 44,938 70% 39,321

Fed Security Collateral (Munis) 3,218 1,584 1,584 1,584

Excess Loan Collateral pledged to the FHLB - - - -

Total Coverage 116,595$ 126,622$ 106,388$ 93,771$

Coverage as a percentage of volatile funds 254.73% 252.09% 169.08% 127.34%

Brokered Deposits (remaining capacity) 46,411 48,728 48,728 48,728

Unsecured Fed Funds Lines 18,000 15,000 15,000 15,000

Total Coverage with Brokered Deposits and Fed Fund Lines 181,005$ 190,351$ 170,116$ 157,499$

Coverage as a percentage of volatile funds with BDeps + FFL 395.45% 378.97% 270.37% 213.88%

Contingency Plan Action Steps, if Needed

Recommended Guidelines: Zone

> 150% Coverage Green * Watch mortgage

< 150% > 100% Coverage Yellow HFS weekly to *Extend lock to close

< 100% Coverage Red manage trends dates to extend cycle

Prior period Current week * Consider borrowing * Manage mortgage HFS

09/30/13 09/30/14 05/11/15 06/09/15 short term from FHLB down

Total Non-Interest Bearing Deposits 53,035 65,904 79,385 88,011 * If appropriate, match * Evaluate benefit of

Total Interest bearing demand deposits 64,211 60,695 67,710 64,790 balance sheet duration sell ing securities

Total Savings and Money Market Deposits 98,832 104,754 109,468 113,703 borrowing with brokered

Total Time Deposits - Retail 78,859 57,027 52,843 58,351 CDs

Total Time Deposits - Wholesale 200 200 - - * Consider extending lock

FHLB Debt 45,000 45,000 65,000 65,000 to close date

ST Wholesale Borrowing 3,822 15,241 7,062 8,872 ** Have created differing stress levels to evaluate what

Total Investment Securities 68,230 59,515 45,148 42,685 those stresses would do to liquidity and how close or

Total Loans, net of unearned income 222,968 256,235 276,532 282,232 over the yellow and red limits the bank is. Trigger points

Total Mortgage loans held for sale 33,233 15,386 40,798 56,173 Red are not in play until the baseline goes yellow or red

Loan to Deposit Ratio (w/MLHFS) 102.56% 104.17% > 120%

Loan to Deposit Ratio (w/o MLHFS) 89.38% 86.88% > 120%

Internet Borrowings Ratio 0.00% 0.00% > 25%

Wholesale Borrowings Ratio 19.28% 18.90% > 55%

Non-Core Funding Dependency Ratio 18.72% 18.64% > 30%

* Evaluate pricing - deposits

and mortg

* Increase selected pricing

- deposits, mortg. Loans

Difference to Static Review

Baseline Actuals Future Stress Scenarios/Possibilities

Liquidity Measures if a volatility event occurs Static Review Stress Test Severe Stress Test

July 2015 64

Create an Early Warning ProcessTrack and Monitor over Periods of Time

Volatile Funds - (in thousands)

Fed Funds 790,000

30% of Public Funds Jumbo CDs 142,068

10% of Non-Public Funds Jumbo 36,097

1% of Non-Jumbo CDs 30,007

25% of Non-Maturity Deposits-Public 48,055

2% of Non-Maturity Deposits-Non-Public 76,876

Total Net Volatile Funds 1,123,103

Total Funding (Ending Balances) 11,708,340

Volatile as % of Total 9.6%

Volatile Funds Coverage - (in thousands)

Fed Funds Sold -

Short-term Investments 4,726

Cash Surplus -

Fed Loan Collateral (80% of Total) 768,663

Fed Security Collateral -

FHLB Loan Collateral 143,922

FHLB Security Collateral -

Excess Collateral (90% of Total) 343,800

Total Coverage 1,261,111

Coverage as % of Volatile Funds 112.3%

20072006

Liquidity Measures

Volatile Funds Coverage Ratio Trend

330%

217%194%

281%

151%164%

178%195%

154%

118% 112%

250%

177%

0%

100%

200%

300%

400%

Nov Dec Jan Feb Mar Apr May June July Aug Sept Oct Nov

Note when this existed at this Bank!!!

CEO decided to grow the bank to

offset earnings shortfalls.

Good or Bad Strategy?

July 2015 65

Liquidity Measures to PolicyAs of June 30, 2012

Volatile Funds Ratio $ Volatile Funds Total Assets Volatile % of Total

Red Yellow Green

Current Quarter 41,597 425,237 9.78% > 20 % 20% - 15% < 15%

Prior Quarter 28,107 395,895 7.10% > 20 % 20% - 15% < 15%

Available Available Sources

Volatile Funds Coverage Ratio $ Volatile Funds Sources % of Volatile Red Yellow Green

Current Quarter 41,597 56,849 136.67% < 100% 100%/150% > 150%

Prior Quarter 28,107 94,873 337.54% < 100% 100%/150% > 150%

Volatile Funds Coverage Ratio with Bdeps + FFL

Current Quarter 41,597 56,849 136.67% < 100% 100%/150% > 150%

Prior Quarter 28,107 94,873 337.54% < 100% 100%/150% > 150%

Loan to deposit ratio Loans Deposits Percentage Red Yellow Green

Current Quarter 198,633 328,499 60.47% > 120% 120%/115% <115%

Prior Quarter 204,351 309,102 66.11% > 120% 120%/115% <115%

Sources Average Balance

(in thousands) % Total Policy

JUMBO CDs 6,230 1.58% 15.00%

BROKERED CDs 0 0.00% 15.00%

INTERNET DEPOSITS 42,440 10.77% 25.00%

FHLB BORROWINGS 60,000 15.22% 25.00%

REPURCHASE AGREEMENTS 1,846 0.47% 15.00%

FED FUNDS (NET) MONTHLY HIGH 0 10.00%

OTHER* 3,822 0.97%

TOTAL WHOLESALE FUNDING 114,338 29.01% 55.00%

TOTAL FUNDING (INCLUDING DEPOSITS) 394,167

* Includes Parent Debt

Liquidity Risk Measures

Wholesale Funding

Policy Limits %

Policy Limits %

Policy Limits %

July 2015 66

Trends of Key Liquidity Ratios

July 2015 67

Incorporate Different Credit StressInto your Forecast of Sources and Uses of Cash

Month

Total 1 2 3 4 5 6 7 8 9 10 11 12

Sources of Cash (Existing)

Short-term Investments

Other Liquid Assets

Bond Cash Flow/Sales - US Treas & Govt Agencies

Bond Cash Flow/Sales - Other

1 to 4 Family Resi Loan Cash Flow received

Other Loan Cash flow received

Planned Loan Sales

Existing Sources of Cash

Current Replacement

Uses of Cash (Existing) Balance %

Bond Replacement(s) - USTs and GSAs

Bond Replacement (s) - Other

DDA Balance/Monthly Outflow

NOW Balance/Monthly Outflow

MMDA Balance/Monthly Outflow

Savings Balance/Montly Outflow

Other NMDs/Monthly Outflow

CD Maturities - Not replaced (6 mos.)

Brokered CD Maturities - Not replaced (6 mos.)

Secured Borrowings - Not Replaced (6 mos.)

Unsecured Borrowings - Not Replaced (6 mos.)

Trust Preferred Dividends to be Paid

Existing Uses of Cash

Existing Balance Sheet - Cash Inflow/Outflow

New Business Activity

1 to 4 Family Resi Loan Originations

Other Loan Originations (net of unused line balances)

New Deposit Balances (non-collateralized)

New Deposit Balances (collateralized - incl. repos)


Pro Forma Cash Inflow/Outflow

Sources of Cash

Uses of Cash


68July 2015

Establish an Early Warning System

• At this point – Baseline Liquidity Position is known

• Define a system of key warning signals or risk indicators (triggers) Need to be institution specific due to variability of balance

sheets, liquidity sources, business practices (operating models), and management philosophies – for Example: A bank that uses brokered funding as a primary source will want a

measure related to that activity

• When developing “triggers” make sure you take into account relevant local, regional, and national market trends and influences Liquidity risk mgt. is about managing the risk of

“ANYTHING” that might radically disrupt the balance between cash inflows and cash outflows

July 2015 69

Key Risk Indicators to Consider in Your Early Warning System

INTERNAL

• Basic Surplus (Deficit) Ratios• Loans to Deposit Ratio• Borrowing to Assets Ratio• Brokered CDs to Assets• Liquidity Gap• Interest Rate Risk Measures• Capital Ratios• Deposit Cash Flows/Decay• NPLs to Loans• Charge-offs and Recoveries• Growth Rates• Need to draw down lines at your

Parent Company

EXTERNAL

• Credit Events and impact to certain concentrations

• Economic Indicators

• Industry Trends in NPLs

• Market Rates/Volatility

• Credit Spreads

• Geopolitical Events

• Natural Catastrophes

• Reputational – sudden loss of key personnel, rating agency downgrades, credit risk management strategies)

Large draws on a credit line is viewed

as a sign of depleting financial

flexibility or even financial distress.

Could increase refinancing risk in a

later distressed period.

July 2015 70

Stress-Testing Do’s and Don’ts

Interest Rate Risk

• EAR

• EVE

Liquidity Risk

• How Much?

• When?

• How Long?

Credit Risk

• How will charge-offs impact capital?

Do…

Know what you are measuring

Leverage existing systems

Summarize and benchmark results

Identify major assumptions

Try to isolate variables

Know what assumptions are based on

Don’t…

Obsess about what’s realistic

Think you can predict it

Use a “one-size fits all” measurement

Obsess over precision

Run more than a handful of tests

Expect a right or wrong answer

71July 2015

Develop Your Action Plans

• Multiple stress tests and scenarios have now helped you identify the need to make changes

• Document responses to each scenario but then develop a set of action plans to address the issues identified in the differing stress tests Outline and report back to the ALCO and your Board if appropriate

Responses depend on type, severity, and duration of the liquidity events so they will differ in complexity and execution effort

Prioritize

Determine stages of action plans as they may be dependent on other activities and plans

Evaluate communication plans if needed and impact on public relations and/or marketing plans

• Keep it simple

July 2015 72

Don’t Forget about your Holding Co.

73July 2015

Holding Company (BHC) Liquidity

• Often overlooked until it is too late – plan in advance If BHC is out of cash, the bank gets taken over

• Make a BHC capital and liquidity forecast

• Sources – few and extremely expensive in tough times Upstream dividends

Proceeds of debt or equity issuance

Selling assets of the BHC

• Uses Downstream dividends for subsidiary banks in jeopardy of falling

below well capitalized levels Comes down as capital to the bank

As part of the bank charter the BHC is there to provide contingent liquidity

Operating expenses – so prior planning would say to move as much to the bank as possible

Debt service

Repayment of debt maturities or debt with breached covenants

Common Stock Dividends

74July 2015

Holding Company (BHC) Liquidity

• Very easy to lose upstream dividend capacity Losses at the bank from increased provision expense, goodwill

impairment charges, OTTI, deferred tax reserves, etc., prevent upstream capability until fully covered via Fed formula

Limited to current calendar year and two prior calendar years - net retained earnings must be positive

Takes a long time to earn out of the window

Do not count on a regulatory exception to be made now or in the future Key point…..”They do not care about shareholders or the BHC”

• Remember that commitment the BHC gave in order to be granted a bank charter was to be a source of strength for the bank and provide liquidity BHC liquidity is normally the first to go

July 2015

AppendixFor Your Reading Pleasure

July 2015

Leonard Matz’

Seven Liquidity Risk Rules

77July 2015

Matz’ 7 Liquidity Risk Rules

1) Liquidity risk is unavoidablea) Banks provide value in our economy as liquidity

intermediaries

b) The task is not risk avoidance – the task is prudent risk taking and to limit risk and manage risk exposure

2) Liquidity risk is very diverse

3) You always have more than you need until you don’t

a) Loss of confidence often triggers unmanageably large cash flows (WAMU example)

b) Confidence is not closely related to liquid assets holdings, capital or ratings (Moody’s and S&P)

c) Confidence is fragile and even for no good reason at all

78July 2015


4) Scenarios are the language of Liquidity Riska) Can’t be measured, discussed, or managed without

multiple simulations and scenarios

b) Liquidity risk is prospective – risk that future events produce adverse consequences

c) Liquidity risk is a consequential risk – real or hypothetical events have to be understood by the underlying cause

d) Liquidity provides some amount of “survival time” during which the crisis is resolved or not

5) Too expensive to hold enough liquid assets under normal conditions

a) Enough to survive a prolonged funding disruption

b) Quickly identify developing funding problems through a well-developed set of key risk indicators (KRI’s)

c) Must be able to quickly and effectively respond to developing funding problems

79July 2015


7) Dollar reduction in funds needed = dollar increase in funds available

a) Regardless of where or how the funds are obtained

b) Liquidity sources:1. Liquidity available from the sale of assets

2. Liquidity available from borrowed funds

3. Liquidity available form net cash flows

8) Rewards from good liquidity risk management are not directly observable

a) Problems avoided or become less serious

b) Harmonizing earnings management with liquidity risk is challenging

1. Cost of not holding enough liquidity are seen in future periods

2. Need to maintain a liquidity cushion is tough to balance

c) Harmonizing internal and external incentives with liquidity risk is challenging

1. Nobody earns a bonus for avoiding a liquidity crisis

July 2015

When You are in Challenging

Times or in a Crisis

81July 2015

In a True Liquidity Emergency

• Few but immediate liquidity sources are available Can strengthen a bank’s resources by holding greater

levels of cash and highly liquid assets Huge cost to margin – especially in a low rate environment

• Utilize and have more wholesale funds-related liquidity sources In theory, they expand reserves available at a lower

cost

However, recent events now question their true availability

• Puts more importance on using on-balance sheet sources of liquidity

82July 2015

Steps to Consider

• Establish which key measures are critical to you and to your regulators Remember that in these times your Regulator is your #1

shareholder

• Make projections of those key measures and run scenarios of realistic outcomes for all potential liquidity threats

• Get the attention of management and the board with scenarios and solutions Set temporary guidelines such as “Loan Growth must be

equal or below Deposit Growth”

Set the tone and educate early so you get buy-in from the front-line

83July 2015

Steps to ConsiderGain consensus on liquidity levels required

• Convince yourself and your regulators that you have enough liquidity Optimize collateral between FHLB, repos, discount window and

deposits to maximize liquidity coverage ratio

Manage loan production and pricing to stay within the funding limits you have

Manage deposit pricing but take care to avoid pricing too high and attracting highly unstable rate-sensitive deposits

Use long-term brokered CDs to grow uncollateralized term funding Protect the unencumbered assets for the last resort

Scale back non-franchise lending Participations, transaction only loans, mezzanine, etc.

Extend debt maturity profile to buy more time

• Strengthen your understanding of your embedded and expected liquidity levels Or have the study completed to fully understand all components

84July 2015

Possible Actions You Can ImplementTo Improve Liquidity

• Short-Term/Immediate

Compete in local markets for deposits

Curtail loan growth and participations

Buy wholesale CDs (Brokered, CDARs, etc.)

Utilize QuickRate internet CDs to spread out maturities

Sell and/or adjust mix of securities (as available)

Sell loans (be careful of GAAP treatment on patterns)

• Longer Term

Implement cash reserve product

Sale/Leaseback of bank owned properties

Move Trust Liquidity accounts onto bank’s balance sheet

Develop online deposit product of your own

July 2015 85

Steps to ConsiderCommunications

As rating agency downgrades or negative quarterly earnings or other adverse news becomes public, have plans in place to

communicate to sales force and the media

• Script branches and relationship managers as to what is really happening and why they do not need to worry (the clients)

• Train personnel on how to present themselves in a confident manner – this is a key to retaining deposits and clients

Front line sales force must become confident in safety and soundness to be able to calm the customer base

Helping media sources to better understand the issues or market forces everyone is under can give you the best odds of avoiding one-sided and uninformed sensational negative media coverage

86July 2015

Steps to Consider

• Capital Management Protect by pulling back on lending – shrink the asset size

and free up risk-based capital

Efficient in creating cash and improving capital metrics but slams the breaks on earnings and local economy

Start early and go much higher than you think

This crisis is lasting much longer so you may have to have enough capital to maintain as much as 3 years of losses

TARP was good for the industry and very good for many banks –don’t listen to the media or investors

Get close to investors and be prepared to make this a full-time job

Become more transparent and paint the picture of how you will get back to profitability

Capital and Liquidity go hand in hand

87July 2015

Steps to Successful Mitigation of EVE Exposure

• Commonly used strategies used to mitigate EVE exposure On-Balance Sheet

Restructure wholesale funding

Restructure bond portfolio

Delever the balance sheet

Add growth/leverage

Implement structured funding or investments

Off-Balance Sheet Hedge floating-rate liabilities

Hedge rollover risk of short-term funding

Utilize a forward-starting SWAP

Purchase an interest rate cap

• Produce “pre-transaction” analyses to help in making the decision(s)

• Execute

• Create “post-transaction” summary and analysis

87

July 2015

Mistakes Banks and Liquidity

Managers Make

89July 2015

Some of the Common Mistakes

1) Too much reliance on correspondent banks

2) Rely too much on “hot” money

3) Too trusting that deposit rate increases will always drive in more depositsa) Today your clients perceive that higher rates than peers

signify bank issues

4) Do not take economic changes seriously – “It will never be that bad again”

5) Lack of understanding of options embedded in the balance sheeta) New products, rules, marketing gimmicks, contingencies,

etc., have driven more optionality in the balance sheet – in almost all aspects

90July 2015


6) Not having a full understanding of the rules as your CAMEL ratings are changed

7) Not having a full understanding and respect of reputational risk

8) Too much reliance on “backward” looking measures

9) Too focused on the bank and forget to strengthen the Parent Company

10) Avoid dealing with concentration risks

11) Do not take Enterprise-Wide risk reviews, processes, reports, and indicators seriously

12) Poor contingency planning

13) Lack of Discipline – willing to change early indicators/measures in policy – feel they are too stringent

91July 2015


• Board Lack of decisiveness in decisions and slow to react

Listen to shareholders vs. spending the time to fully understand what could happen and not being prepared to deal with the needed changes

Lack of understanding how the economy can impact banks

Not willing to take drastic steps early Cut dividends

Borrow and extend maturities

Unwilling to hurt earnings – so they become slow to enhance capital and liquidity

Too slow to fully understand how hard it is to fund the Parent Company

92July 2015

Wholesale Funding

• Banks use this because the initial cost of funds are low when compared to other liabilities or similar maturities

• Many wholesale funding instruments have embedded options May have variable interest payments or average lives or

redemption values that are dependent on external measures Reference rates, indexes, or formulas

They include putable, callable, convertible, and variable rate advances with caps, floors, collars, step-ups, or amortizing features

They also may contain prepayment features

• Increases a bank’s sensitivity to market and liquidity risks Result – virtually impossible to model these in your IRR sensitivity

scenarios as well as any stress testing of your liquidity position

93July 2015

Wholesale Funding – Brokered Deposits

• Considered Toxic by the FDIC and other Regulators – not insured

• With enough capital – good funding source Primary reason – does not require collateral which then leaves the

remaining unencumbered assets available to be pledged elsewhere

• Key Questions you should answer when using Brokered CDs: Use as a funding source – if so, what % of assets are funded with

Brokered CDs? Has the % grown and if so, is it at appropriate levels?

Any discussion on the condition of their use – specific mention of capital requirements? Do policy limits exist?

Does liquidity policy permit use of this funding option? Does it note that the bank must remain “well capitalized?”

When do you use brokered CDs vs. FHLB funding? Do you have policy restrictions on all wholesale types of funding?

What alternative funding sources does your bank have to replace the possible loss of brokered CDs or FHLB advances?

July 2015

Additional IRR and Liquidity

Risk Information for Your

Reading Pleasure

July 2015 95

Spectrum of Tactical and Strategic ActivitiesMcKinsey Risk Management Practice

• Conduct stress-testing and scenario analysis to understand impact of potential outcomes and implications for enterprise and specific businesses

• Develop vertical and horizontal view of risk across Bus

• Engage in a robust dialogue for each type of risk exposure, especially complex and exotic products

• Systematic update of model assumptions to reflect new reality

• Install system/infrastructure to obtain timely information and take corrective actions

Improve Transparency of Risk Exposures

• Assess liquidity risk and funding plan for the institution as a whole

• Review liquidity-impacted businesses (securitization and structured product businesses, leveraged finance, credit origination/distribution)

• Stimulate liquidity shock scenarios and develop contingency plans

Improve Transparency on Liquidity Position

• Launch comprehensive program (across all asset classes and functional levers) targeted at:

• Refining account acquisition strategies (focus on higher quality channels)

• Improving underwriting and collateral management

• Reducing exposure to risky customers/products

• Increasing cure/reduce delinquency rates

• Make significant investments to upgrade collections/loss mitigation and workout capabilities

Focus on Loss Mitigation

• Conduct an independent holistic review of all risk management practices to evaluate “effectiveness”

• Board conducts self-assessment on risk and proactively seeks more information on magnitude and type of risk exposure

• Review compensation structure to ensure ownership and alignment with risk

Strengthen Governance

• Develop a true enterprise-wide balance sheet management approach

• Retool credit portfolio management to cover a broader set of asset classes (trading book, counterparty exposure, pipeline/commitments, retail assets)

• Review/revise risk policies for high-risk asset classes (all proprietary trading limits, credit policies for broker-channel, LTV ratio in high-risk geographies)

Realign Risk Appetite

July 2015 96

Strategic Balance Sheet ManagementA Key Differentiator between Strong and Weak Banks

Risk Committees

• Active balance sheet risk management

• Enhance risk/return profile

• Modify plans – tactical and strategic

ALM Process

• Import position and market data

• Calculate risk measures (income and value)

• Generate ALM report package (monthly)

Analyze Reports

• EVE sensitivities (contractual cash flows)

• Net Interest Income (NII) simulation

What-If Simulations

• Analyze risk exposure – forecast and stress

• Measure impact of hedging strategy

• Measure sensitivity to key assumptions

• Understand behavioral dynamics

July 2015 97

Critical Success FactorGovernance and Its Framework

• Effective governance drives the entire balance sheet management process

• ALCO is the action vehicle with a clear mandate and well articulated policies and procedures

• Line of business buy-in and cooperation is essential

• Modeling is designed to support the governance process (Anything else - ancillary and secondary)

• Reporting and feedback align various components• Enforce accountability, create action items, e.g. hedging

• Must be value-added - pricing optimization, elimination of expensive options, funding optimization

Organizational Design is Critical to Effective Process Management

• Education and qualification of resources

• Creation of risk management culture – Make it your DNA

All Players Must Understand Roles and Responsibilities

• Governance, Organizational Structure, and Responsibilities

• Data and Assumptions, Risk Models, Internal Controls and Audit

• Monitoring and Reporting

Framework

July 2015 98

Key Questions ALCO Must Answer

How much liquidity do we have?

• Operational, reserve, and contingency

How accessible is it and what are the relative costs?

Do we derive most of our funding from core or non-core sources and how have those trends been in the past few years?

• If non-core – which funding sources do we use?

• What must we do to retain those sources and to remain in a strong condition and maintain a strong capital position?

How much operational liquidity may we need short-term and longer term?

If market or economic conditions change, how will our liquidity needs and cash availability change?

What crisis or events could markedly affect our operational needs and impede our access to reserves and/or contingency sources?

Do we have a sufficient early warning system that could prompt actions prior to a problem?

July 2015 99

Key Questions ALCO Must Answer

What actions would we take in the event of a liquidity crisis, and how long could we sustain operations?

• Was it due to short-term or long-term factors?

Do we have adequate processes and controls in place that will ensure actions plans will be executed successfully?

Is the information on our balance sheet exposure to interest rate changes, timely and accurate?

Do we have the right policies and risk tolerances in place?

Do we monitor the right exposures and economic conditions and have we set up the proper guidelines as to what we do when these change?

Do we fully understand all the underlying assumptions and “back test’ our forecasts?

Is our A/L Model robust and sophisticated enough to provide us with the needed level of information to help us generate the needed action plans?

100July 2015

Characteristics of Ineffective ALM Committees

• The CEO does not attend

• ALCO members are unsure of what the Committee is to accomplish

• ALCO members are uncomfortable with the validity of the risk information presented

• The agenda is cluttered with “review items,” leaving insufficient time for decisions and providing a lot of excuses to avoid making decisions

• IRR reports provided to committee members are too voluminous, complex, or late to support informed decision making

• Too much time is spent discussing the current interest rate outlook instead of alternative management decisions

• ALCO discussions are dominated by the individuals directly responsible for monitoring the IRR exposure

• Risk management decisions are not implemented

• The results of previous decisions are not measured

• The only managed portion of the Bank’s IRR is the IRR is assets, liabilities, or off-balance sheet positions that fall directly within the organizational responsibilities of the individuals who are responsible for measuring IRR

• Risk management decisions are made in response to the present situation and short-term objectives. Longer term strategic considerations are given little or no thought

• Management of the bank’s liquidity position is inconsistent with the interest rate policy guidelines adopted by the ALCO

• The profitability and riskiness of key loan and deposit products are not monitored by the ALCO

July 2015 101

Regulatory Guidance for Supervisors

Review bank’s contracts for embedded options or features that may affect the liquidity and sensitivity to market risks

• Collateral agreements, collateral maintenance requirements, triggers for increases in collateral

Assessment of the bank’s management processes for identifying and monitoring risks of the various terms for each borrowing contract

• Including penalties and option features over the life of the contract

• Does the bank do stress tests and did they do these tests before they entered into the borrowing agreement

• Did the bank rely on a 3rd party advisor and if so did management review all the underlying assumptions and test results

Evaluation of management processes for controlling risks, including interest rate risks from borrowings as well as liquidity risks

• Proper controls include contingent funding plans in the event borrowings or lines are terminated

• Hedges or others plans for minimizing the adverse affects resulting from penalties or interest rate changes or other triggers

Determination as to whether the A/L Committee or Board is fully informed of the risks and ramifications of complex wholesale borrowing agreements

• Prior to engaging in the transaction as well as on an ongoing basis

Determination as to whether funding strategies regarding wholesale borrowings, especially those with optionality, are consistent with both the portfolio objectives of the bank and the level of sophistication of the bank’s risk management

102

Net Interest Income

Measures % change in NII typically for the next 12 mos. given change in interest rates

• Parallel instantaneous shift

• Flattening or steepening

Advantages

• Single period risk measure based on earnings that is relatively easy to calculate without many assumptions

• Relatively intuitive and easy to implement and understand

• Directly linked to reported financial results and therefore easy for investors to relate to

Challenges

• Single period risk measure provides only a limited view of bank’s risk

• Earnings do not reflect fully the economic impact of interest rate movements

• Derivative positions are required to be reported on marked to market basis

July 2015

Set Net Interest Income LimitsBut Don’t Treat EVE as a Secondary Measure

Equity Value of Equity

Measures % change in marked to market (MTM) value of assets net of liabilities given

change in interest rates

• Parallel instantaneous shift

• Flattening or steepening

Advantages

• Multi-period risk measure that provides more complete assessment of the IRR the bank is taking

• NPV/MTM based measure captures the economic impact of interest rate movements

• Support determining market risk capital

Challenges

• Viewed as complex to implement, results are as good as assumptions and many assumptions, such as demand deposit duration and mortgage prepayment, are difficult to develop and have high uncertainty

• Less intuitive and difficult to understand

July 2015 103

Moving to Best PracticesSources of On-Balance Sheet Liquidity

Immediate

• Cash and sale of excess unpledged liquid investments

• Scheduled short term investment portfolio maturities

• Ongoing loan pay-offs from maturities and prepayments

• Rollover CDs, core deposit retention, and natural deposit growth

Intermediate

• Maturities and culling of high value (at par and above)

• Ongoing loan payoffs from maturities and prepayments

• Increase rate sensitive deposit balances (CDs, high rate MMDA)

• Scheduled increases in long term wholesale funding

• Restrictions on new lending (to the extent possible) and investing

Longer Term

• Sales of below market investments and loan sales

• Ongoing loan payoffs from maturities and prepayments

• Increase non-rate sensitive deposit (i.e. core deposits)

• Sale/leas-back of fixed assets, sale of branches, etc.

• Net earnings (if applicable)

Source: William J. McGuire – “The Liquidity Challenge –

Understanding sources of liquidity: a new old fashioned view”

104July 2015

On Balance Sheet Liquidity

• Equal to Embedded + Expected Sources Poor awareness of “Expected” liquidity will unduly limit

the amount of it included in reported liquidity positions

Understates true levels of both total and incremental liquidity available Can lead to unnecessary levels of stored liquidity, or

Excessive lines of credit

• The key aspect to identifying embedded and expected sources is to avoid margin Leakage If you quantify the borrower and depositor liquidity-

related behaviors, expected liquidity can be accurately determined

Quantify the past to understand the future

105July 2015

Quantifying Expected Liquidity SourcesOne Key to Success

• Assemble historic data Granular enough to recognize special behavior influences

Consumer vs. business, fixed vs. variable, MMDAs by tier…

• Quantify Expected Liquidity Behaviors Analyze the data collected to establish underlying behaviors

Normally a complex process

Some can be simple like averaging prepayments over time, computing average decay rates for core deposits, rollover % for CDs…

• Forecast Future Expected Liquidity Sources Create an equation system by all behaviors

Prepayments, total balances, retention…

Under multiple conditions

• Implement a Program to Ensure Continued Forecast Accuracy Formalized back testing – actual vs. forecasted

Note economic conditions and changes

July 2015 106

Federal Banking Agencies Policy StatementReleased on March 19, 2010

Emphasizes the importance of cash flow projections, diversified funding sources, stress testing, as cushion of liquid assets, and a formal well-developed contingency funding plan as the primary

tools for measuring and managing liquidity risk

• Effective corporate governance consisting of oversight by the board and active involvement by management in an institution’s control of liquidity risk

• Appropriate strategies, policies, procedures, and limits used to manage and mitigate liquidity risk

• Comprehensive liquidity risk measurement and monitoring systems (including assessments of the current and prospective cash flows or sources and uses of funds) that are commensurate with the complexity and business activities of the institutions

• Active management of intraday liquidity and collateral

• An appropriately diverse mix of existing and potential future funding sources

• Adequate levels of highly liquid marketable securities free of legal, regulatory, or operational impediments, that can be used to meet liquidity needs in stressful situations

• Comprehensive contingency funding plans that sufficiently address potential adverse liquidity events and emergency cash flow requirements

• Internal controls and internal audit processes sufficient to determine the adequacy of the institution’s liquidity risk management process

107July 2015

Joint Advisory on Interest Rate RiskReleased January 6, 2010

• Properly identify a bank’s true interest rate risk (IRR) Significant increases/decreases in market rates (+/-400bp)

Shock increase/decrease in market interest rates

Abnormal changes in yield curve slope (flattening and steepening)

Alternative deposit pricing rates

Balance sheet mix change/growth/contraction

• Sensitivity stress Option/convexity

Alternative retail deposit replacement/migration NMD/CD mix

CD duration

Alternative wholesale funding strategies – short vs. long

Alternative investment strategies – fixed vs. adjustable, duration

Alternative lending activity – fixed vs. variable, caps, floors, spreads

Alternative decay rates in EVE calculations

July 2015 108

Principles for the management and supervision of liquidity risk

Principle 1:

• A bank is responsible for the sound management of liquidity risk.

• A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources.

• Supervisors should assess the adequacy of both a bank's liquidity risk management framework and its liquidity position and should take prompt action if a bank is deficient in either area in order to protect depositors and to limit potential damage to the financial system.

Fundamental principle for the management and

supervision of liquidity risk

July 2015 109


Principle 2:

•A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system.

Principle 3:

•Senior management should develop a strategy, policies and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity.

•Senior management should continuously review information on the bank’s liquidity developments and report to the board of directors on a regular basis.

•A bank’s board of directors should review and approve the strategy, policies and practices related to the management of liquidity at least annually and ensure that senior management manages liquidity risk effectively.

Principle 4:

•A bank should incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole.

Governance of liquidity risk management

July 2015 110


Principle 5:

• A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk. This process should include a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons.

Principle 6:

• A bank should actively monitor and control liquidity risk exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to the transferability of liquidity.

Principle 7:

• A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding. It should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providers to promote effective diversification of funding sources.

• A bank should regularly gauge its capacity to raise funds quickly from each source. It should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates of fund raising capacity remain valid.

Principle 8:

• A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.

Measurement and management of liquidity risk

July 2015 111


Principle 9:

• A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets.

• A bank should monitor the legal entity and physical location where collateral is held and how it may be mobilized in a timely manner.

Principle 10:

• A bank should conduct stress tests on a regular basis for a variety of short-term and protracted institution-specific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a bank’s established liquidity risk tolerance.

• A bank should use stress test outcomes to adjust its liquidity risk management strategies, policies, and positions and to develop effective contingency plans.

Principle 11:

• A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations.

• A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust.

Principle 12:

• A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources.

• There should be no legal, regulatory or operational impediment to using these assets to obtain funding.

Measurement and management of liquidity risk

July 2015 112


Principle 14:

• Supervisors should regularly perform a comprehensive assessment of a bank’s overall liquidity risk management framework and liquidity position to determine whether they deliver an adequate level of resilience to liquidity stress given the bank’s role in the financial system.

Principle 15:

• Supervisors should supplement their regular assessments of a bank’s liquidity risk management framework and liquidity position by monitoring a combination of internal reports, prudential reports and market information.

Principle 16:

• Supervisors should intervene to require effective and timely remedial action by a bank to address deficiencies in its liquidity risk management processes or liquidity position.

Principle 17:

• Supervisors should communicate with other supervisors and public authorities, such as central banks, both within and across national borders, to facilitate effective cooperation regarding the supervision and oversight of liquidity risk management.

• Communication should occur regularly during normal times, with the nature and frequency of the information sharing increasing as appropriate during times of stress.

Principle 13:

• A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position.

The Role of Supervisors

July 2015 113

Basic Surplus (Deficit) Method

Taken from:Article: Managing

Liquidity Risk

By Michael R. Guglielmo

2007

Managing Director at

Darling Consulting Group

Basic Format

July 2015 114

Basic Surplus (Deficit) MethodLiquid Assets section

• Inventory of assets that can be converted to cash within the next 30 days Cash or cash equivalents (i.e., fed funds sold), sold with minimal loss, can be pledged as collateral, or

they mature within the next 30 days

• Assets that can be used for borrowing normally are US Govt and agency securities and agency-issued mortgage-backed securities and collateralized mortgage obligations (MBS, CMOs, GNMAs)

Only market value

of pledgeable

assets with

related haircut

should be used

July 2015 115

Basic Surplus (Deficit) MethodShort-Term/Potentially Volatile Liabilities & Coverages Section

• Identify and categorize any liabilities that might create liquidity exposure Those that would arise should customers/lenders lose confidence in the financial stability of the bank

Includes: total unsecured borrowings maturing within 30 days and coverage of potential deposit runoff

• Unsecured borrowings – include outstanding balances in Fed Funds purchased and unsecured borrowings from other banks Unsecured = extremely vulnerable to runoff – which also means contingency coverage must equal 100%

• Deposit coverage – 2 components: time deposits and non-maturity deposits (NMD) Time deposit runoff assumptions = ones maturing in 30 days and with sources, concentrations, relative

costs, stability, and reliability influencing the coverage defined

Normally 25% for stable/reliable retail sources and 25%-100% for other products depending on risks

NMD – normally use 5%-10%...........NOTE: in past 4 years these assumptions have changed dramatically

July 2015 116

Basic Surplus (Deficit) MethodQualifying FHLB Loan Collateral and Brokered Deposit Access section

• Core basic surplus can be enhanced FHLB – represents just-in-time inventory management of your funding

Brokered CDs – can be looked at as strategic reserves, or funding that can be used when your “just-in-time inventory begins to drop to levels below your policy guidelines Reliable and available without collateral but can be restricted when credit concerns exist

FDIC considers these as toxic

Federal Reserve – provides catastrophe insurance in the event of a systemic liquidity crisis

Other – securities that can be sold or collateralized (muni’s) unsecured lines of credit, and other secured lines

117July 2015

Contingency Liquidity Plan

• Quantification of both on- and off-balance sheet liquidity with policy minimums

• Documentation of discussions regarding loan and deposit growth for near-term (90 days) and longer-term (9-12 mos) Includes implications of resulting cash shortfalls and excesses

• Contingency liquidity policy – procedures manual format

• Contingency Liquidity Plan Risk monitor report with ratios, trends, situations considered to be early warning

indicators

Cash flow projections at least 1 yr reflecting net cash positions, assumptions for deposit rollovers, loan renewals, investment activity, and wholesale funding rollovers

Quantification of funding capacity from unpledged assets and various policy approved wholesale funding sources available

Descriptions and modeling of a series of stress scenarios with impact on customer behavior and availability of credit

Pre-emptive strategies that can be implemented to solve or mitigate liquidity stresses

Quarterly updates of contingency plan

Board reporting of contingency planning activities, stress testing results, and required actions

July 2015

South Carolina

Bankers School

DECEMBER 2007–JANUARY 2008 BANK ACCOUNTING & FINANCE 3

Michael R. Guglielmo is Managing Director at Darling Consulting Group,

Newburyport, Massachusetts. Contact him at mguglielmo@darlingcon-

sulting.com.

Managing Liquidity RiskBy Michael R. Guglielmo

Six ways to strengthen your liquidity risk–management process.

Managing liquidity risk is becoming more challenging as balance sheets grow in complexity and dependence upon the

capital markets for funding continues to rise. What were once considered contingency sources of li-quidity such as the Federal Home Loan Bank (FHLB advances), broker-dealers (repurchase agreements and brokered deposits) and national CD listing ser-vices (QuikRate) are now mainstream and integral parts of liquidity management processes used by many fi nancial institutions today. Examiners un-derstand the market forces that have led bankers to seek alternative funding sources and acknowl-edge their contribution to an effective liquidity management process (and profi tability). But this increased dependence introduces additional issues and risks that institutions must understand and actively manage.

Regulatory agencies have been actively updating their handbooks and are arming their examin-ers with a new set of liquidity risk–management guidelines and standards. These guidelines ap-propriately emphasize the need to use a liquidity risk–management process that is commensurate with the liquidity management activities and risk profi le of the institution being examined. Institutions that plan to rely on the capital markets to fund future growth need to demonstrate their understanding of the risks involved and have the appropriate mea-surement and management processes in place. The credit crunch that occurred in the summer of 2007 was a wake-up call to many liquidity managers in the fi nance industry: Times are changing and we need to be prepared.

There are eight key questions your asset-liability management committee (ALCO) and the board should be able to answer relative to your current liquidity and liquidity risk–management process:1. How much liquidity (operational, reserve and

contingency) do we have? 2. How accessible is it and what are the relative

costs? 3. How much operational liquidity may we need

short term and longer term?4. If market or economic conditions change, how

could our liquidity needs and cash availabil-ity change?

5. What crisis or events could markedly affect our operational needs and impede our access to reserves and/or contingency sources?

6. Do we have a sufficient early warning system that could prompt actions prior to a problem?

7. What actions would we take in the event of a liquidity crisis, and how long could we sustain operations?

8. Do we have adequate processes and controls in place that will ensure action plans will be executed successfully?

If you or your management team has diffi culty answering any of these questions, your liquidity and liquidity risk–management process may be in need of a makeover. Here are six steps you can take to strengthen your liquidity and liquidity risk–management process.

Managing Liquidity Risk

Look for measures that are easily accessible or already reported.

4 BANK ACCOUNTING & FINANCE DECEMBER 2007–JANUARY 2008

Step 1: Determine How Much Liquidity You Have

To fully understand your liquidity position, you need to begin with a working defi nition with which everyone in your organization agrees—and one upon which measures can be established. A defi nition we fi nd works well is “the ability to raise cash quickly (within 30 days) with minimal principal loss and at a reasonable cost.”

The next step is to evaluate your current liquidity measures to see if they support this defi nition. For those institutions using the traditional regulatory measures such as the loan/deposit ratio or the volatile liability dependency ratio,you should quickly con-clude that neither of these backward-looking mea-sures can truly quantify an institution’s future cash availability or accessibility. Organizations that rely primarily upon traditional cash fl ow projections (a sources and uses forecast) can fail in meeting this defi nition as well, since future cash fl ows (beyond 30 days) will not help when you need cash most—quickly. Moreover, all of these measures focus just on on-balance-sheet liquidity and do not factor in access to off-balance-sheet sources, which most fi nancial institutions employ and rely on with regularity.

The approach that we fi nd best encompasses both on- and off-balance-sheet liquidity is the basic surplus (defi cit) method. The basic surplus (defi cit) approach has been effectively used for the last 25 years by fi nan-cial institutions throughout the United States and the world to manage their liquidity and funding. Exhibit 1 shows a typical basic surplus (defi cit) schedule.

This report begins with quantifying your liquid assets. This section is essentially an inventory of the assets that can be converted to cash within the next 30 days either because (1) they are cash equivalents (for example, federal funds sold), (2) they can be sold with a minimum of principal loss, (3) they can be pledged as collateral for borrowings, or (4) they mature within the next 30 days.

For cash and cash equivalents, you can include cash-related assets not required for operational purposes (federal funds sold, overnight deposits or investments, money market mutual funds, etc.). As-sets that can be sold quickly with minimal or no loss

may include student loans, the guaranteed portion of Small Business Administration (SBA) loans and the like. Assets that can be used as collateral for bor-rowings are primarily U.S. government and agency securities and agency-issued mortgage-backed securities and collateralized mortgage obligations (MBS and CMOs). These assets are considered liquid regardless of their accounting classifi cations (held to maturity [HTM] or available for sale [AFS]), since use as collateral does not require or constitute a sale.

Since assets that may be used for borrowings cannot already be pledged for other purposes, the balances of each asset category must be reduced

by the amount of pledges already made. In addition, only the market value of the pledgeable assets should be used in the cal-culation, along with the related haircut that would

be applied, since borrowing capacity would be based upon these two elements.

Once the liquid assets have been inventoried, it is important to identify and categorize any liabilities that might create liquidity exposure, particularly those that would arise should customers or lenders lose confi dence in the fi nancial stability of the bank. In this short-term liabilities section, we would include (1) total unsecured borrowings maturing within 30 days and (2) coverage for potential deposit runoff.

In the case of unsecured borrowings, we would in-clude outstanding balances in federal funds purchased and unsecured borrowings from other fi nancial insti-tutions. Because they are unsecured, they would be extremely vulnerable to runoff in the event of a loss of confi dence. Therefore, runoff (for contingency cover-age) should always be maintained at 100 percent.

The parameters defi ned for deposit coverage should be broken down into two components: time deposits and nonmaturity deposits (NMD). For time deposits, an assumption for runoff should be applied to depos-its scheduled to mature within the next 30 days, with sources, concentrations, relative costs, stability and reliability infl uencing the coverage defi ned. In general, banks typically use 25 percent for stable/reliable retail sources and anywhere from 25 percent to 100 percent for other products depending upon the relative risks. For NMD, banks typically will use anywhere from fi ve percent to 10 percent depending upon the coverage de-



I. LIQUID ASSETSOvernight Funds Sold & Short-Term Investments (avg. balance, if wide daily fl uctuations) 4,000

UST & AgencyMBS/CMOs

(-5% Haircut)Security CollateralTotal Market Value of Securities 450,000 125,000Less Securities Pledged to:

FHLB -22,500 -10,500 Wholesale Repos 0 0 Retail Repos/Sweeps -150,000 -50,000 Municipal Deposits 0 0Other 0 0

Available/Unencumbered Security Collateral 277,500 61,275 338,775Overcollateralized Securities Pledging Position 50,000Government & Agency Guaranteed Loans (SLMA/SBA unpledged) 5,000Cash fl ow (< 30 Days) from securities not listed above 0Other Liquid Assets (Interest-Bearing Deposits, Money-Market Mutual Funds, etc.) 5,000

TOTAL LIQUID ASSETS 402,775

II. SHORT-TERM/POTENTIALLY VOLATILE LIABILITIES & COVERAGESMaturing Unsecured Liabilities (< 30 Days) 0Deposit Coverages

25% of Regular CDs maturing < 30 Days 6.2 % of total

deposits

2,500

30% of Jumbo CDs maturing < 30 Days 5,000

10% of Other Deposits of Total Deposits 30,000

Additional Liquidity Reserve(s) 0

TOTAL SHORT-TERM/POTENTIALLY VOLATILE LIABILITIES & COVERAGES 37,500

BASIC SURPLUS 365,275 36.5%

III. QUALIFYING FHLB LOAN COLLATERALA. Maximum Borrowing Line at FHLB is Not AvailableB. Qualifying Loan Collateral at the FHLB (net of haircut) 150,000C. Excess Loan Collateral (if A < B)Maximum Borrowing Capacity (Lesser of A or B) 150,000Collateral Currently Encumbered by Outstanding Advances 100,000

REMAINING FHLB LOAN-BASED BORROWING CAPACITY 50,000

BASIC SURPLUS W/FHLB 415,275 41.5%

IV. BROKERED DEPOSIT ACCESSMaximum Board-Authorized Brokered CD Capacity (per policy) 190,000Current Brokered CD Balances 25,000

REMAINING CAPACITY TO UTILIZE BROKERED CDs 165,000BASIC SURPLUS W/FHLB & BROKERED CDs 580,275 58.0%

Exhibit 1. Basic Surplus (Defi cit) Schedule

{



sired and the historical stability of these funding sources. While core deposit studies help in identifying historical trends and evaluating the stability of the deposit base for a given institution, a broader industry perspective of historical liquidity events or runs should be taken into consideration. It is important to keep in mind that the assumptions used for deposits represent contingencycoverage. Management and the board must ultimately use judgment in developing the assumptions and relate the liquidity results to the assumptions applied. In the case of Exhibit 1, the assumptions used for deposit con-tingency coverage can be off by over 900 percent before the core liquidity profi le approaches a negative result.

To calculate the basic surplus (available or excess liquidity) or the basic defi cit (liquidity shortfall), short-term liabilities are subtracted from liquid assets. To provide a perspective relative to historical capacity, results can be shown as a percentage of total assets. This will allow management to effectively evaluate trends and assess the bank’s capacity to fund ad-ditional growth or supplement unplanned deposit runoff (beyond the coverage already assumed).

The core basic surplus (defi cit) in Exhibit 1 refl ects the cash and funding available (net of contingency cover-age) from brokerage fi rms and the FHLB (excluding loan collateral). This core basic surplus can be enhanced by incorporating a few additional liquidity sources:

FHLB. Access to the FHLB (using qualifying loans as collateral) represents a just-in-time in-ventory management of your funding. Brokered CDs. Use of the brokered CD market can be looked at as your institution’s strategic reserves, or funding that can be used when your just-in-time inventory begins to drop to levels below the policy guidelines. Brokered CDs can also be issued to pay down FHLB borrowings and increase the just-in-time inventory. While reliable and available without collateral, orders can take some time to fill and access can be restricted when there are credit concerns. Federal Reserve. Establishing a borrowing ar-rangement with the District Federal Reserve Bank (FRB) under the borrower in custody (BIC) program with collateral that cannot be used to support borrowings elsewhere essentially provides catastrophe insurance in the event of a systemic liquidity crisis in which the FHLB or brokered CD markets are not available.

To the extent available, other liquidity items can be summarized and footnoted in this report. These

sources may include (1) other securities that could be sold or collateralized (for example, corporate or municipal bonds), (2) unsecured lines of credit such as federal funds lines and (3) secured lines such as the FRB’s BIC program.

Step 2: Estimate How Much Liquidity You Need

Once you have established your current liquidity position and can quantify your institution’s capacity to fund planned growth or potential deposit runoff, it is important to understand how future changes in your balance sheet could affect your liquidity posi-tion. A projection of sources and uses would be an appropriate tool in this case. The appropriate level of detail and the time frame will vary depending upon the complexity of your balance sheet, your liquidity profi le and data available. Your projection should at least extend over a three-month horizon. While examiners may encourage you to expand this forecast over six or even 12 months, the level of accuracy—and consequently the utility—for most institutions would diminish signifi cantly. If future cash fl ow information is presented to the ALCO and the board in summary form, it may be worthwhile to separately maintain the details related to con-tractual and noncontractual cash fl ow runoff along with the estimates for new volume. Understanding the relative contribution of contractual cash fl ows, cash fl ows derived from your behavioral models or estimates and new volume could be important when you begin to look at contingency and stress-testing scenarios later in this process. Exhibit 2 illustrates what a core liquidity matrix may look like.

Step 3: Establish an Early Warning System

Once you know your baseline liquidity position, it is important to defi ne a system of key warning signals or risk indicators (triggers) that can alert manage-ment to an increased state of liquidity duress. These triggers need to be institution specifi c, since balance sheets, liquidity sources, business practices and management philosophies vary. For example, an in-stitution that actively relies upon securitization and



sales activities as a primary source of funding will want to establish a measure related to that practice. A bank that actively uses brokered funding will want a measure related to that activity. When developing these potential triggers, management should discuss and take into consideration relevant local and broad-er (national) market trends and infl uences. Exhibit 3 summarizes common key risk indicators.

The extent of the risk-measurement process should be commensurate with your institution’s size, complexity and liquidity risk profile. In de-termining the specific measures or ratios, try to keep it simple and look for measures that are eas-ily accessible or already reported. For institutions with more robust financial modeling and report-ing systems or data warehousing tools, more sophisticated metrics can be derived, tracked and used as part of the risk-measurement process (for example, loan-loss migration, retail deposit stability, loan prepayment, product pricing).

Step 4: Stress-Test Your Funding Needs and Availability

Most institutions are accustomed to stress-testing analyses in the context of earnings- and value-at-risk through their interest rate risk–management practices. Surprisingly, few institutions look at the information embedded in that analysis and its po-tential impact on liquidity. Under varying interest rate environments, cash fl ows and estimated mar-ket values are changing. If they are changing a lot, your institution’s liquidity capacity and funding needs could be markedly affected.

For institutions for which liquidity is of growing concern, additional alternative stress-testing analysis should be performed with some regularity. In addition to projecting existing cash fl ows or values in differing environments, alternative assumptions that refl ect po-tential events can be applied. We have found this type of analysis can be highly effective in evaluating the po-tential severity of a liquidity event and your institution’s readiness to handle that event. While general event defi -nitions are okay, a well-designed plan that is customized to your institution is preferred by examiners.

How many scenarios or alternatives is enough? What kind of reporting should you prepare and

review? These questions depend upon your institution’s risk profi le (liquidity, interest-rate risk and capital). In general, institutions that are highly levered and have a notable dependence on the capital markets for funding should be doing more than an institution with high capital, low interest rate risk and strong liquidity. As with interest rate risk management, it is important not to overdo it: We typically recommend developing a set of scenarios that represent three levels of liquidity duress (moderate, high and signifi cant). For each of these scenarios, management should evaluate the potential impact on a number of items including collateral values, tightening col-lateral standards that reduce borrowing capacity, deposit outfl ows, capital hits that affect the ability to access the brokered market, the need to securi-tize and sell assets at severe losses, at what point do we have to utilize our BIC line at the Federal Reserve, etc.

In terms of ALCO and board reporting, a liquid-ity scorecard that summarizes all of the liquidity measures, the key risk indicators and their levels relative to policy guidelines (perhaps color-coded red/yellow/green) would be appropriate. In addi-tion, including historical trends would be benefi cial from the standpoint of understanding how we got to the current liquidity state.

Step 5: Outline Management’s Responses

Once the liquidity events are identifi ed, management needs to outline its expected responses for each event. For larger organizations, establishing a liquidity crisis team that meets and reports periodically to ALCO and the board may be benefi cial. This team of specialists should include those primarily responsible for the execution of specifi c activities outlined in your insti-tution’s liquidity contingency plan.

Depending upon the type, severity and duration of the liquidity events, responses will vary in terms of complexity and execution effort. Minimally, each action plan should include a prioritized sequence with procedural instructions, communication protocol and key contact information (personnel responsible, external contacts). Since actions may be staged with initial responses followed by longer-



Exhibit 2. Sample Core Liquidity Planning MatrixSources and Uses of Funds

Sources of Cash (Existing) Total 1 Month 2 Months 3 Months 4 Months 5 Months 6 MonthsShort-Term In-vestments $- $- $- $- $- $- $- Other Liquid Assets $- $- $- $- $- $- $-

Bond Cash Flow / Sales—US Trea-suries & Govern-ment-SponsoredAgencies $- $- $- $- $- $- $- Bond Cash Flow/Sales—Other $- $- $- $- $- $- $-

1- to 4-Family Residential Loan Cash Flow Received $- $- $- $- $- $- $-

Other Loan Cash Flow Received $- $- $- $- $- $- $- Planned Loans Sales $- $- $- $- $- $- $- Existing Sourcesof Cash $- $- $- $- $- $- $-

Uses of Cash (Existing)

Replace-ment Percent-age Total 1 Month 2 Months 3 Months 4 Months 5 Months 6 Months

Bond Replacement(s)—USTs & GSAs 100.0% $- $- $- $- $- $- $- Bond Replacement(s)—Other 100.0% $- $- $- $- $- $- $-

Current Balance

Decay Estimate(mos) Total 1 Month 2 Months 3 Months 4 Months 5 Months 6 Months

DDA Balance/Monthly Outfl ow $- 0.0% $- $- $- $- $- $- $- NOW Balance/Monthly Outfl ow $- 0.0% $- $- $- $- $- $- $-

MMDA Balance/Monthly Outfl ow $- 0.0% $- $- $- $- $- $- $-

Savings Balance/Monthly Outfl ow $- 0.0% $- $- $- $- $- $- $-

Other Nonmatur-ing Deposits/Monthly Outfl ow $- 0.0% $- $- $- $- $- $- $-



term activity, identifying timelines for each activity would be appropriate. When we assist clients to develop action plans, we encourage them to initially keep it simple so it can be easily understood and executed. Over time, these plans can be enhanced to include more substantive activities such as public relations efforts and detailed marketing plans.

Step 6: Document Your Process and Periodically Test Liquidity Sources

All this effort is well and good but if it is poorly documented and not periodically tested, all of your work could be for naught. Take the time to

Exhibit 2. Sample Core Liquidity Planning MatrixSources and Uses of Funds

CD Maturities—Not Replaced (6 mos.) $- 0.0% $- $- $- $- $- $- $-

Brokered CD Maturities—Not Replaced (6 mos.) $- 0.0% $- $- $- $- $- $- $- Secured Borrow-ings—NotReplaced (6 mos.) $- 0.0% $- $- $- $- $- $- $-

UnsecuredBorrowings—Not Replaced (6 mos.) $- 0.0% $- $- $- $- $- $- $-

Trust-PreferredDividends to be Paid $- $- $- $- $- $- $-

Existing Uses of Cash $- $- $- $- $- $- $-

Existing Balance Sheet—Cash Infl ow/Outfl ow $- $- $- $- $- $- $- New Business Activity Total 1 Month 2 Months 3 Months 4 Months 5 Months 6 Months

1- to 4-Family Residential Loan Originations $- $- $- $- $- $- $-

Other Loan Originations (net of unused line balances) $- $- $- $- $- $- $-

New Deposit Balances (Non-collateralized) $- $- $- $- $- $- $-

New Deposit Balances (Collateralized—includingrepos) $- $- $- $- $- $- $-

New Business Activity—Cash Infl ow/Outfl ow $- $- $- $- $- $- $- Pro Forma Cash Infl ow/Outfl ow $- $- $- $- $- $- $-



adequately document your liquidity risk–man-agement process. As part of this documentation, include a complete description of what you do in terms of liquidity monitoring and management process, your liquidity management philosophy and why your institution has selected (or exclud-ed) specific risk measures and key risk indicators. If done well, this document can (1) serve as your liquidity management playbook; (2) inform and educate all of your significant stakeholders (man-agement, the board, funding providers, examiners and independent risk auditors); and (3) reduce the risk of poor execution.

If any of the defi ned action plans include use of external resources or conduits, it is imperative to periodically contact and test these sources to ensure availability in a time of need. If the fi rst time you call an institutional broker for deposits is when you are having issues, the broker is going to be reluctant to assist. Periodically tap the brokered market, use repurchase agreements, or solicit deposits though a national CD listing service.

Successfully Manage Liquidity Risk

Continuing to effectively fund asset growth is going to be one of the key challenges facing the banking industry in the years to come. All finan-cial institutions need an approach and a plan for managing liquidity and funding that is practical and provides safeguards against an institution-specific or systemic liquidity crisis. Institutions that are most successful in managing liquidity and liquidity risk will do the following:

Maintain an appropriately detailed measur-ing and monitoring process that includes a comprehensive collateral inventory manage-ment process, accurate sources/uses forecasts and alternative funding source diversity.Implement a liquidity stress-testing pro-cess that can quantify the bank’s ability to withstand moderate, significant and severe liquidity events.Develop and monitor an early warning sys-tem that can detect issues before they become problems.Document and maintain a liquidity contingen-cy/action plan that can be relied upon in the event of various liquidity events or crises.

It is important to recognize that one size does not fit all and that the success of a liquidity risk management process is a function of not only its design but also the people involved in its management and execution. By engaging your management team, as well as outside expertise, the right process can be developed and imple-mented. As stated in one of Jack Welch’s rules for success, bankers need to “control [their] own destiny or someone else will.”

Exhibit 3. Key Risk Indicators

Internal ExternalBasic surplus ratio(s) Credit eventsLoan-to-deposits Economic indicatorsBorrowings-to-assets Industry trends in

NPLsBrokered CDs-to-assets Market rates/volatilityLiquidity gap Credit spreadsIRR measures Geopolitical eventsCapital ratios Natural catastrophesDeposit cash fl ows/decay

NPLs/loans

Chargeoffs/recoveries

Growth rates

This article is reprinted with the publisher’s permission from Bank Accounting & Finance, a bimonthly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher’s permission is prohibited.

To subscribe to Bank Accounting & Finance or other CCH Journalsplease call 800-449-8114 or visit www.CCHGroup.com.

All views expressed in the articles and columns are those of the authorand not necessarily those of CCH or any other person.

spitman

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Reprinted from Bank Accounting & Finance, December 2007 Copyright 2007 CCH Incorporated www.taxcchgroup.com All rights reserved.

Darling Consulting Group 978.463.0400

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Liquidity Challenge

8 Questions to Ask, 6 Steps to Take

by: Steve Cocheo Executive Editor

ABA Banking Journal

[This article was posted on March 24, 2009 on the website of ABA Banking Journal, www.ababj.com, and is copyright 2009 by the American Bankers Association.]

Most banks can forecast what’s going to happen on the loan side of the house fairly well, but deposit forecasting often leaves a great deal to be desired. And thus it is that liquidity, drawing strongly on deposit patterns, that represents one of the industry’s biggest question marks.

That’s especially because of evolutions on the funding side that

have rendered liquidity harder to peg than ever, according to Michael R. Guglielmo, managing director at Darling Consulting Group, Inc., Newburyport, Mass., and speaker at a conference session entitled, “Liquidity Contingency Planning: Are you prepared?”

See Page 2 for complete article


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Most banks can forecast what’s going to happen on the loan side of the house fairly well, but deposit forecasting often leaves a great deal to be desired. And thus it is that liquidity, drawing strongly on deposit patterns, that represents one of the industry’s biggest question marks.

That’s especially because of evolutions on the funding side that have rendered

liquidity harder to peg than ever, according to Michael R. Guglielmo, managing director at Darling Consulting Group, Inc., Newburyport, Mass., and speaker at a conference session entitled, “Liquidity Contingency Planning: Are you prepared?”

“Capital is the lifeblood of a bank,” said Guglielmo, “but liquidity is the heart

and soul.”

Liquidity takes center stage

Guglielmo defines liquidity as follows: “the ability to raise cash quickly with minimal principal loss and at a reasonable cost.”

Community bank funding poses an increasing challenge, Guglielmo said, at

the same time that banks require greater need for balance sheet growth to sustain earnings. Banks face a limited supply of retail funding, and thus have developed a greater dependence on capital markets for funding, just as the capital markets sources have become less cut-and-dried source. Wholesale sources have grown more volatile in recent times. Regulators have become less enamored of certain banks leaning on brokered CDs and other wholesale funding sources, for example. Banks may face greater “haircuts” on collateral securing repurchase agreements, may face reduced access to Federal Home Loan Bank advances, and more.

Guglielmo pointed out that while regulators acknowledge the need and

benefits of wholesale funding, they also see the necessity for more precise structuring of bank liabilities now that the blend has grown beyond traditional core deposits.

This comes at a time when the market for loan sales, notably mortgages, has

been through a crippling metamorphosis. Guglielmo noted that the secondary market for many mortgage assets “evaporated in less than six month.”


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Eight questions to ask As a result of shifting patterns, Guglielmo said, there has been a convergence

of operational liquidity planning and contingency liquidity planning. Sources once regarded as measures for backup in unexpected exigencies are now also part of ordinary funding.

Unfortunately, he said, there is a lack of meaningful, forward-looking liquidity

planning in many banks. Nowadays, he said, bankers have to conduct liquidity planning in an integrated fashion with planning for interest-rate risk, market risk, credit risk, budgeting and planning, policies, and processes and controls.

“Regulators want more formalized liquidity plans,” said Guglielmo, “and you

want to be able to justify your liquidity program.” The consultant presented eight key questions to ask, which lead into action

steps. The questions:

1. How much liquidity do we have? Operational? Contingency? 2. How accessible is each source of liquidity, and what are the relative costs? 3. How much operational liquidity do we need, short-term and longer-term? 4. If market conditions change, how could our liquidity needs and cash availability change? 5. What crisis or events could markedly affect our operational needs and impede our access to reserves and/or contingency sources? 6. Do we have sufficient early warning systems that could prompt actions prior to a problem? 7. What actions could we take in the event of a liquidity crisis, and how long could we sustain operations? 8. Do we have adequate processes and controls in place that will ensure action plans will be executed successfully?


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Six action steps to take

From those eight questions, Guglielmo moved to six steps bankers can take:

1. Determine how much liquidity you have. Guglielmo noted that a fundamental flaw of most traditional measures of liquidity is that they look backwards.

Take the loan-to-deposit ratio—it’s a historical measure, not forward looking.

In addition, many traditional liquidity measures don’t incorporate off-balance sheet sources of liquidity.

Guglielmo said an effective measurement process should include:

• Balance sheet liquidity—available cash and securities. This requires looking at liquid assets, such as unencumbered securities that aren’t already collateralizing liquidity sources such as municipal deposits or repurchase agreements. This analysis must also look at short-term sources of liquidity that could disappear in a crisis, such as short-term deposits and Fed funds purchased. This evaluation must realistically consider how much of this liquidity would stick and how much would quickly depart.

• “Just-in-time inventory”—sources such as Federal Home Loan Bank funding.

This analysis must consider how much is available, how much is already being used, and how much will remain available in tougher circumstances.

• A “strategic reserve”—sources tapped when necessary, such as reliable sources

of brokered deposits. A fundamental measure here is the maximum level authorized by the bank’s board, versus how much has been utilized already.

• “Catastrophe insurance”—sources such as the Federal Reserve. This piece also

includes secondary collateral sources, such as corporate securities, equity securities, and municipal securities that can be readily sold or offered as collateral.


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All of these considerations go into calculating the bank’s “basic surplus” of liquidity. Compared to the bank’s needs and potential needs, it will dictate what Guglielmo called the bank’s “real world” liquidity.

This takes the bank’s planning away from looking solely at cash-on-hand and

cash flow. The bank doesn’t want to have too much of its liquidity in cash, but must be able to count on realistic amounts of the other types. Furthermore, he warned, the outside sources must be based on established relationships, so the bank can realistically expect to go to those sources when needed. (He has more to say on this, further on.)

2. Estimate how much liquidity you need.

Guglielmo said a bank must look forward, at its sources and uses of funds, to get a realistic handle on liquidity needs. He showed listeners a spreadsheet that contained both sources of cash and uses of it one month, two months, and further out. He noted that regulators nowadays like to see a six-month horizon in place. He said that at least a three-month horizon should be in place.

Further, Guglielmo said that the horizons should be considered in three

contexts besides “normality.” These are: “significant” liquidity crunch; “severe” liquidity crunch; and “doomsday,” to use his labels.

“Examiners do want you to think about doomsday events,” warned

Guglielmo. He asked bankers to consider how long their banks could maintain their

activities if brokered CDs and other wholesale sources of funds went away.

3. Establish an early-warning system.

No one ratio or approach is right for every bank, Guglielmo stressed. Banks must determine what measurements will serve as a warning to management and the board given each bank’s own balance sheet and risk profile.

In addition, no bank is an island; management must take into account both

local and national market elements. He went through many potential ratios to consider. The ones that apply to the bank’s circumstances should be gathered into a


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“scorecard” centralizing all of these factors and examining them in the three stress levels outlined above.

“Get something on paper, and start to follow it, and learn from it,” said

Guglielmo. Among his recommendations for internal factors to consider: basic surplus

ratios; borrowings-to-assets; brokered CDs-to-assets; liquidity gap; interest-rate-risk measures; capital ratios; deposit cash flows/decay; nonperforming loans/loans; chargeoffs/recoveries; growth rates; and loan-to-deposit ratio. Regarding the latter, a good point to keep an eye on is changes indicating heightened funding requirements. Also, look at deposit balances not connected to maturing deposits and at increasing usage of line of credit commitments. The speaker recommended many other such measurements.

Among Guglielmo’s recommendations for external factors to build into the

scorecard: credit events; economic indicators; industry trends in nonperforming loans; market rates/volatility; credit spreads; geopolitical events; and natural catastrophes.

4. Stress-test your funding needs and availability.

Guglielmo noted that while most banks stress-test their balance sheet for

interest-rate risk, few stress-test for liquidity risk. Yet, he pointed out, “if your interest-rate risk process results in notable

changes in cash flow and valuation, your liquidity sources and uses will change, too.” Guglielmo covered key points to evaluate for liquidity stress. One is potential changes in collateral values. If the market-value of a security

that could be used, or is being used, to secure outside liquidity, were to fall, then this would have to be addressed to maintain or access liquidity with that instrument. Similarly, tightening standards by the sources of that liquidity must also be anticipated in various scenarios. The potential for having to sell or securitize loans at severe losses must be taken into account as well.

Another such factor: capital ratios. If capital takes a significant hit, that could

affect the bank’s ability to access the brokered CD market.


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5. Outline management’s responses to various situations.

All the analyses outlined up to this point only matter in that they will drive

preparation, and, in the event, action by management. Guglielmo recommended detailed action plans for various scenarios. These

would include instructions on what will be done, who will handle each piece, who must be contacted internally and externally, and the anticipated timelines each plan will progress along.

He recommended that larger organizations put together a Liquidity Crisis

Team, which would meet periodically and report to the ALCO and the board on its preparations and activities.

Through all of this, Guglielmo’s watchword is: “Keep it simple and enhance

the abilities over time.”

6. Document your process, and periodically test sources.

Regulators will want to see evidence of all the foregoing effort, as well as justification for the approaches taken. Guglielmo recommended using the document embodying all of this as the bank’s liquidity playbook. And he suggested that key players inside and outside the bank be informed of what the bank has prepared.

And then, keep the approach real, not something on the shelf. “I can’t emphasize it enough,” said Guglielmo. “Make sure you test your

liquidity sources.” He warned that failing to do so will lead to what has already been seen, banks

who called on their backup sources of liquidity, only to be greeted by a voice on the other end of the phone asking, “Who are you?”


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Michael R. Guglielmo Managing Director

Darling Consulting Group, Inc. [email protected]

Tel: 978.463.0400 x159 With nearly 20 years in asset/liability management, Michael provides both technical and strategic consulting to a diverse group of financial institutions in the U.S. and abroad. Michael is also a frequent author and speaker on a variety of balance sheet management topics. During his tenure at DCG, he has served in various capacities including Director of Financial Analytics. In addition, he has served as a technical resource for the development of DCG’s products and services. Prior to joining DCG in 1992, he managed the asset/liability management and strategic planning process for a large regional bank in the northeast. Michael is a graduate of Fairfield University with a degree in Economics. He lives in Massachusetts with his wife and three children.

This article was posted on March 24, 2009 on the website of ABA Banking Journal, www.ababj.com, and is copyright 2009 by the American Bankers Association.

Liquidity Measurement and Management

by: George K. Darling Chief Executive Officer

Darling Consulting Group

Introduction

An important area of balance sheet management that does not receive enough attention in many banks is the measurement and management of liquidity.

A focused liquidity management process can significantly enhance profitability as a result of improved loan strategies and pricing, higher yields on investments and reduced funding costs.

See Page 2 for complete article


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Introduction

An important area of balance sheet management that does not receive enough attention in many banks is the measurement and management of liquidity.

A focused liquidity management process can significantly enhance profitability as a result of improved loan strategies and pricing, higher yields on investments and reduced funding costs.

Reliance on traditional liquidity measures such as the loan to deposit ratio, volatile liability dependence, longer-term cashflow forecasts or non-core funding dependency analysis will not provide a bank with the proactive process required in today’s environment. The following is a discussion of a more proactive approach that has been successfully utilized by a number of banks of varied asset sizes and mix. Liquidity Defined

Preceding any discussion of liquidity measurement, it is necessary to have agreement on the definition of liquidity. For any financial institution, liquidity is defined as “having money when you need it to meet loan commitments and funding replacements.” Further enhancing this definition: “liquidity for a financial institution is its ability to raise cash quickly (within 30 days), without principal loss and at a reasonable cost.” Traditional approaches are no longer valid

With the definition of liquidity described above, financial managers should ask themselves if traditional measures are still valid:

• Loan to Deposit Ratio – This ratio has long been used as a measurement of liquidity. However, when this ratio was first introduced, investment alterna-tives were typically limited to U.S. Governments. At the same time, the only source of funding for community banks was local deposits. Therefore, if a bank had a 60% loan to deposit ratio, by definition, it had 40% of its assets in highly liquid assets (i.e. U.S. Governments or cash equivalents). Today, that same bank could be invested in below market corporates, municipals or collateralized mortgage obligations. How liquid are these investments and what is the bank’s ability to convert them to cash quickly without principal loss? In most situations, the loan to deposit


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ratio will not provide a bank with a measurement of liquidity within the definition outlined above.

• Twelve Month Cashflow Analysis – If a bank needs to raise cash quickly

(e.g. within thirty days) what good is knowing its twelve month cashflow? In the event of an abnormal funding requirement or a “run” on the bank’s deposits, this analysis is useless and does not meet the measurement requirement outlined above.

• Volatile Liability Dependence/Non-Core Funding Dependency – The

Volatile Liability Dependency measurement has recently been replaced in most regulatory agencies by the Non-Core Funding Dependency ratio (NCFDR). The NCFDR is defined as all borrowings plus certificates of deposit and open account deposits over $100,000 plus brokered deposits, less short-term investments, divided by long-term assets. The objective is to determine the percentage of longer-term assets supported by non-core funding.

Unfortunately, this ratio considers some very reliable funding sources as volatile while ignoring the fact that many deposits considered “core” in the NFCDR are actually more prone to run-off than implied. For example, all advances from the Federal Home Loan Bank (FHLB) are considered as volatile while all retail CDs (CDs under $100,000) are considered as non-volatile. FHLB advances are fully collateralized and offer no risk of loss to the FHLB. As a result, it is very unlikely that FHLB borrowings will not be renewed at maturity so long as the collateral is still intact. History has proven that retail certificates of deposit are often not renewed at maturity if the depositor is concerned about the financial viability or reputation of the bank or is attracted by a competitor’s above-market “special”. Finally, as with the other liquidity measures discussed above, the NCFDR does not measure a bank’s liquidity as defined above.


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Basic Surplus (Deficit)

In today’s environment, managers of financial institutions need a liquidity measurement process that provides answers to the following questions:

1. How much liquidity does the bank have? (How much cash can the bank raise quickly without principal loss and at a reasonable cost?)

2. How much liquidity does the bank need to cover expected volatility of its funding base?

3. How is the bank’s liquidity carried/invested? Can the yield on the liquidity portfolio be improved?

4. What sources of reliable, cost effective funding does the bank have available to provide a “just in time” inventory of funding?

5. How does the current liquidity position relate to the funding needs of the bank?

6. What are the implications of the current liquidity position and expected funding requirements for deposit pricing, loan pricing and investments?

Any approach utilized for liquidity measurement and management should

enable financial managers to answer these questions. One approach that most banks would find effective for this purpose is the Basic Surplus (Deficit) measurement combined with short-term cashflow forecasting of funding requirements.

The Basic Surplus (Deficit) is a measure of the cash a financial institution can cost-effectively raise within a thirty-day timeframe, without principal loss, adjusted for the estimated volatility of liabilities.

The first step is to measure the cash that can be raised quickly without principal loss (Liquid Assets). This requires an inventory of assets that can be converted to cash quickly through maturity or use as collateral for borrowings. Items considered to be Liquid Assets might include:

1. Fed Funds Sold that converts to cash daily. 2. Cash and Due net of float and reserves (cash that could be used to fund

outflows in the event of a deposit run). 3. The market value of unpledged securities that can be used as collateral in the

financial marketplace for repurchase agreements or may be used as collateral at the Federal Home Loan Bank. These items include U.S. Governments and


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Agencies; mortgage-backed securities guaranteed by GNMA, FHLMC, or FNMA; and, collateralized mortgage obligations (CMOs) that are eligible for use as collateral. If securities that are currently used for collateral will be freed up over the next thirty days, they should be included in this calculation. Collateral pledged beyond 30 days is excluded from consideration.

4. Loans that could be sold within 30 days, without loss, such as a mortgage loan warehouse, student or SBA loans.

5. Cashflow maturities under thirty days from items such as municipals, corporates, bankers acceptances, Eurodollar CDs, term fed funds, etc.

6. Other assets that might be converted to cash quickly without principal loss. These might include equities with market value above book value, mutual fund holdings, etc.

7. Residential 1-4 family homes that could be used to secure borrowings from the Federal Home Loan Bank.

The next step is to estimate the liabilities that might leave the bank in the

thirty-day period following a loss of confidence in the financial institution (Short Term Liabilities). For purposes of this exercise, the bank should attempt to estimate which liabilities might leave after three quarters of reported losses and a negative article in the local paper. These short-term liabilities would usually include:

1. Federal funds purchased. 2. 0-100% of Jumbo CDs maturing in the next thirty days. Usually the expected

run-off for planning purposes is 20-40%. 3. Repurchase agreements that mature in the next thirty days that might not be

renewed (Note: the collateral will be freed up in the Liquid Assets calculation outlined above).

4. Municipal deposits collateralized by municipal securities that are expected to run off over the next thirty days. (Municipal securities don’t readily qualify as collateral elsewhere.)

5. 0-50% of Consumer CDs that are maturing in the next thirty days (Note: the attrition of these deposits may be mitigated by federal insurance.)

6. Other volatile liabilities, which might include some estimate of core deposit run-off, Treasury tax and loan (TT & L) run-off, etc.

The third step in measuring liquidity is to calculate the coverage of Liquid

Assets to Short-Term Liabilities. The difference between the two is referred to as the Basic Surplus/Deficit as shown in Exhibit I.


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Exhibit 1

Liquid Assets •

•

•

•

•

•

•

•

Fed Funds Sold _______________

Cash and Due (net of float and reserves) _______________

Market Value of U.S. Governments and Agencies not pledged beyond thirty days (@ 100%) _______________

Market Value of GNMA, FNMA and FHLMC* securities not pledged beyond thirty days (@ 95%) _______________

Market Value of eligible CMOs not pledged* beyond thirty days (@ 90%) _______________

Loans held for immediate sale (or that could be sold within thirty days) _______________

Cashflow maturities < 30 days _______________

Other marketable assets _______________

Total Liquid Assets _______________

Short Term Liabilities •

•

•

•

Fed Funds Purchased @ 100% _______________

Repurchase Agreements < 30 days _______________

0-100% of Jumbo CDs < 30 days _______________

0-50% of Consumer CDs < 30 days _______________

Total Short-Term Liabilities _______________

Liquid Assets – Short-Term Liabilities = Basic Surplus/Deficit

*NOTE: Borrowings using mortgage-backed securities are usually limited to between 90-95% of current market value to protect against principal paydowns.


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Exhibit II shows a Basic Surplus calculation for a $468 million dollar bank as of December 31, 1998. Outlined below are some of the implications of this bank’s current liquidity position.

1. This bank’s liquidity position is very strong. The ability of this bank to raise

cash quickly without principal loss amounts to $308,986,000 made up of:

Liquid Assets $192,371,000 • • • •

FHLB Advances (using 1-4 family residential loans)* 37,410,000 Corporate Securities (market value > bank value)* 30,862,000 Municipal Securities (market value > bank value)* 48,343,000

$308,986,000 * See “Other Items” at bottom of Exhibit II

2. The bank has little dependency on volatile funding sources. Short-term

liabilities only amount to $35.9 million.

3. The Basic Surplus position is significantly above the bank’s policy limit of 5% which means there is significant capacity to fund additional loan or asset growth without the need for additional deposit growth.

4. Much of the liquidity held on the balance sheet is in cash or cash equivalents

that could be invested in higher yielding investments. This short-term liquidity position could expose this bank to significant exposure to falling rates if rates fall and results in reduced current income if there is any slope to the yield curve.

5. Secondary sources of liquidity are strong with large portfolios of corporate

and municipal securities that could be sold if necessary. This should be the last source of liquidity accessed since a portfolio where market value exceeds bank value cannot be replaced in the current environment without reducing income, extending maturities or increasing liquidity or credit risk.

6. It would seem that this bank should be pricing the majority of its deposits in

the middle of the market since it does not need to attract more funding for the balance sheet.


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7. Aggressive loan pricing might be appropriate for this bank to absorb the excess liquidity so long as the loans emphasized meet the bank’s credit standards.

Overall, the Basic Surplus/Deficit allows managers of financial institutions to

better understand how much liquidity they have and how they are carrying it. However, by itself, it does not measure how much liquidity the institution may need. To answer this question one more step is required.


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Analyzing Funding Requirements

To determine how much liquidity a financial institution needs requires management to forecast cash requirements over some horizon to determine if at the end of the horizon, the Basic Surplus/Deficit will still be adequate. This requires management to establish minimum levels beyond which liquidity should not be allowed to decline.

To forecast the Basic Surplus/Deficit necessitates that loan officers involved in the A/L process be required to provide estimates of net new loan fundings over some horizon, for example, ninety days. Additionally, executives responsible for deposit gathering should also forecast anticipated net deposit flows. A forecast of future liquidity could be accomplished as follows: Basic Surplus/Deficit at beginning of period _______________ less: net new loan fundings* _______________ plus: net deposit flows _______________ plus: cashflow maturities 31-90 days ** _______________ Equals: Basic Surplus/Deficit at Horizon _______________ * Includes loan sales ** Excluding U.S. Treasury and Agency securities already included in starting Basic Surplus/Deficit position

The forecast of funding requirements over a horizon has implications for both investment strategies and deposit pricing. If the basic surplus is materially increasing, excess cashflows should be anticipated and could even be pre-invested. An expected increase in liquidity should also ensure that the financial institution is not pricing liabilities at the top of the marketplace. Conversely, a drop in liquidity below a minimum acceptable level dictates that investments be kept relatively short or in securities that can be easily used as collateral for borrowings and that liability prices be set at the upper end of the market.


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Conclusion

The use of the Basic Surplus/Deficit for measuring liquidity combined with a short-term cashflow forecast can provide management of a financial institution with an improved structure within which to develop investment strategies and liability pricing policies. The net result should be more informed balance sheet management, an improved net interest income contribution from the liquidity portfolio and more intelligent liability pricing.

George K. Darling Chief Executive Officer

Darling Consulting Group, Inc. [email protected]

Tel: 978.463.0400 x118 George Darling is the Chief Executive Officer of the Darling Consulting Group (DCG), a firm that provides comprehensive business solutions to financial institutions, primarily in the areas of Balance Sheet Management and Strategic Planning. Mr. Darling’s professional experience includes: thirty years with his own company, two years as a senior executive with a $2 billion financial institution; two years with a Big Five Accounting firm and ten years with IBM. He is a nationally recognized resource for assisting financial institutions in the areas of interest rate risk management, liquidity management and capital planning. Mr. Darling is a contributing editor to the monthly Bank Asset/Liability Management newsletter, and a co-author of The Business of Banking for Bank Directors published by Robert Morris Associates. Mr. Darling is a graduate of the University of Massachusetts, Amherst, Massachusetts.

This article was written in March 1999.


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