At a minimum, poor liquidity management can reduce bank earnings. At the other extreme, it can jeopardize the bank’s continued operation. Because liquidity is such a crucial matter for banks, they should have policies in place to manage their liquidity positions. These policies represent the board’s guidance to bank management and staff on supervising the bank’s liquidity position.
As is true with respect to any policy matter, responsibility for an appropriate liquidity policy rests with the board of directors. It is the board’s job to ensure that management has established the necessary procedures and controls to manage the bank’s liquidity position effectively, to keep abreast of its liquidity, to ensure management compliance with board liquidity guidance and to plan for the bank's liquidity contingencies and ongoing liquidity needs.
With regard to planning for liquidity contingencies and ongoing liquidity needs, plans should:
- Look to the future, taking into account past trends in funding as well as prospective events such as budgeted growth, asset-liability mix, desired net interest income, interest rates, market and economic conditions and competitor behavior.
- Coordinate with the bank’s other plans and policies, the activities of which may affect the bank’s liquidity position (for instance, loans and investments).
Your bank’s liquidity position may be managed through its asset and liability management policy, investment policy or some other set of policies. What is important is that board-approved policies address liquidity in some manner and that the board monitors both compliance with these policies and the need to change them as necessary.
After you complete this lesson, you should be able to:
- List guidelines and parameters that are often included in liquidity policies.
- State why monitoring for compliance with liquidity policies is important.
How familiar are you with your bank’s liquidity policy? During this lesson, be sure to review the Try This at Your Bank exercise: Liquidity Policy.
Goals of the Liquidity Policy
Policies on liquidity vary from bank to bank based on individual operating environments, customers and needs. Also, policies change over time as a bank’s situation and environment change. Typically, liquidity policies will:
- Set out goals or objectives to be accomplished. For example, that liquidity requirements are monitored and that expected and unanticipated funding needs are met on an ongoing basis at the least possible cost.
- Coordinate decisions made within operating areas that affect a bank’s liquidity position and establish clear responsibility for decisions affecting liquidity.
- Provide strategies for managing the bank’s liquidity position, such as management of the bank’s investment portfolio and the potential for investments to provide liquidity.
- Set guidelines delineating appropriate levels of liquidity. Examples of some typical guidelines are:
- A limit on the loan-to-deposit ratio.
- A limit on the loan-to-capital ratio.
- A general limit on the relationship between anticipated funding needs and available sources for meeting those needs. For example, the ratio of anticipated needs/primary sources shall not exceed ___ percent.
- Primary sources for meeting funding needs. These would include core deposits (demand accounts, savings accounts) and noncore deposits (brokered deposits, large CDs) and other funding sources (federal home loan bank advances).
- Flexible limits on the percentage reliance on a particular liability category. For example, negotiable certificates of deposit should not account for more than ___ percent of total liabilities.
- Limits on the dependence on individual customers or market segments for funds.
- Flexible limits on the minimum/maximum average maturity for different categories of liabilities. For example, the average maturity of negotiable certificates of deposit shall not be less than ___ months.
- Desired maturities for loans and investments.
- Minimum liquidity provision to sustain operations while necessary longer-term adjustments are made.
Finally, liquidity policies often provide for handling policy exceptions, periodic evaluation of policy adequacy and policy review and approval, at least annually, by the board of directors.
Besides board-approved policies that address liquidity, it’s important that directors get reports at monthly board meetings on compliance with these policies. This ensures that you, as a director, are aware of your bank’s liquidity position and its consistency with policy. It’s also important that any review of reports and discussion of issues identified from them be duly recorded in the board’s minutes.
How does your bank monitor its compliance with liquidity policies? Consider the Try This at Your Bank exercise: Compliance with Liquidity and Investment Policies
Elements of a Liquidity Policy
In skeletal form, a liquidity policy might include the following:
Objective: To fund assets and obligations as they become due in the most cost-effective way without unduly jeopardizing income potential.
Who: Set out a line of responsibility, such as:
- Who is responsible for daily implementation of the bank’s liquidity policies and procedures?
- Who monitors the bank’s daily liquidity positions?
- Who provides and receives reports on the bank’s liquidity positions?
- Who establishes policies that guide operations?
What: Outline the rules, including:
- What internal/external events will be considered for their impact on the bank’s liquidity?
- What measures are used to judge liquidity and what are the limits on those measures?
- What are acceptable and unacceptable liquidity sources for the bank?
- What are appropriate uses of liquidity sources and limits on what those sources can be used to fund?
- What contingency plans should the bank have in place in the event it loses its normal funding channels?
- What should be done when there is an exception to the policy?
- What reports should be generated to keep management and the board apprised of the bank’s liquidity position?
When: Detail time frames for tasks under the policy to be completed, such as:
- When should management receive a report on the bank’s liquidity position?
- When should internal/external events be reviewed for their bearing on the bank’s liquidity?
- When should the board review the bank’s liquidity position?
- When should the liquidity policy be reviewed by the board to ensure it reflects the board’s current risk tolerance and position on appropriate funding practices?
- When should the bank’s liquidity-management strategies, processes, and procedures be subject to internal/external review to ensure that they are appropriate and in keeping with the bank’s current access to funding and liquidity needs?