|6. Asset & Liability Committee|
|What you need to know||Join the meeting||Review the Reports||The board´s response|
|Watch the Video||Liquidity and Market Risk Management||Managing Liquidity Through
Assets and Liabilities
|Liquidity Policy||The Investment Policy||Using Reports to Manage
All bank assets are a potential source of liquidity. In an extreme situation, even the bank’s building can be sold to provide funds, provided there is enough time to execute the transaction. Even so, banks generally use shorter-term or readily marketable assets for liquidity purposes.
Of course, when you need cash, the best thing to have on hand is cash. That’s why vault cash, deposits at banks and other cash items are considered a bank’s primary reserve. The problem with cash is that it doesn’t earn a return. Because of this, banks often hold relatively little vault cash, keeping their liquidity reserves in assets that earn interest instead.
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Most banks use their securities portfolio to maintain a liquidity reserve. For the most part, securities can be liquidated quickly and at relatively little cost. At the same time, they provide the bank with interest income. As a result, a bank’s securities portfolio may be thought of as a liquidity shock absorber. When loan demand is low, banks take their excess funds and invest in securities to earn a return. When loan demand returns, they sell their securities to make higher yielding loans. Because of this, securities are often thought of as a bank’s secondary reserve.
Before 1993, banks simply reported their securities holdings as investment securities on their balance sheets. Since 1993, investment securities are reported according to the need they meet. This change in reporting is a beginning step in market value accounting for banks and is intended to give a clearer picture of a bank’s true financial condition. Securities are now slotted into one of three categories:
Securities purchased for the return they provide, with the bank intending to hold them until they mature, are reported as held-to-maturity securities on the balance sheet. These securities continue to be reported as they were before 1993, at the face value, adjusted for any premium or discount.
Securities purchased with the intention of resale before they reach maturity are reported as available-for-sale securities on the balance sheet. Unlike held-to-maturity securities, available-for-sale securities are reported at fair market value. This difference in accounting treatment reflects the fact that available-for-sale securities can be sold at a moment’s notice and, as such, they are reported at what they can be sold for at each point in time. Movements in interest rates cause the value of these securities to change over time, and these changes are recorded as unrecognized gains or losses, which are taken as an adjustment to capital.
This adjustment to capital is shown in the equity portion of the balance sheet. For Insights Bank, the fair market value of available-for-sale securities is $38,000 below their purchase price and, thus, capital is reduced by this amount.
It’s important to note that, currently, unrecognized gains and losses are not explicitly taken into consideration for determining capital adequacy by the federal banking agencies. However, if your bank has large unrecognized losses in its available-for-sale securities and is experiencing liquidity strains, examiners will voice concern. The reason for their concern is that available-for-sale securities may have to be sold to meet liquidity needs, at which point unrecognized losses become recognized, decreasing earnings and capital.
Recognized gains and losses can also arise from securities in the trading account. These securities are held explicitly for short-term income and are purchased with the intention of a quick sale at a profit. Consequently, trading-account securities are also reported at fair value, and the gains and losses are recognized in each quarter in the income statement. (Contrast this with the treatment of available-for-sale securities, which pass their gains and losses through to capital each quarter, but do not formally recognize them in earnings until the securities are sold.) For most banks—especially smaller banks—trading account securities usually make up a small part of securities holdings compared with held-to-maturity and available-for-sale securities.
There are a couple of issues to look for when you review recognized gains and losses on your bank’s income statement. One issue is the practice of “gains trading”—selling available-for-sale securities with gains in them to boost net income. It’s okay to see occasional gains, but the bank shouldn’t rely on continuous gains as a source of income. After all, if all securities with gains are sold, then only those with losses remain. If these losses must be taken when the bank has a liquidity need, then future earnings would be adversely affected.
You should also remain aware of the misclassification of your bank’s securities holdings. You shouldn’t see very many gains or losses in the “sale of held-to-maturity securities” line item on the bank’s income statement. After all, at maturity, the bank only receives the return of its principal. If you see large gains, it may be that the bank has classified its securities holdings as held-to-maturity when they are actually being used as available-for-sale or trading securities.
This doesn’t mean your bank can’t occasionally report gains and losses on held-to-maturity securities sold prior to maturity. The Financial Accounting Standards Board, however, says that, in general, there are only certain instances when held-to-maturity securities can be sold before they reach maturity. They include such things as:
The common characteristic among all these events is that they are out of the control of and hold unknown risks for the debt holder. In addition to these circumstances, securities that are within 90 days of maturity may be sold in advance of maturity. Securities on which the holder has already collected at least 85 percent of the principal can be sold in advance of maturity as well.
If your bank sells some of its held-to-maturity securities to meet liquidity needs prior to maturity or in circumstances not covered by the Financial Accounting Standards, the sale is said to taint the bank’s held-to-maturity securities holdings, and all of its held-to-maturity securities must be reclassified as available-for-sale. In addition, any unrecognized gains or losses in the reclassified securities must be taken into account in the bank’s reported capital.
An added problem in using held-to-maturity securities to meet liquidity needs is that the bank’s securities holdings have been misreported on its Report of Condition and Income filed with its primary federal banking supervisor. Civil money penalties can be assessed for filing inaccurate Call Reports.
How familiar are you with the Available-for-Sale and Held-to-Maturity Securities at your bank?
Liability management came into vogue in the 1960s and 1970s and became an almost unlimited funding source for banks. Bank solvency and lender willingness to lend money to banks were the only constraints to raising funds.
Liability management involves managing a bank's deposits and other borrowings to meet its funding needs. The largest component of a bank's liabilities is typically core deposits. Core deposits are generally the lowest-cost funding source because federal deposit insurance lessens depositor concerns about the return on their funds.
Banks that have a large and ready source of core deposits find liability management an easier task than those that must rely on more volatile, noncore deposits. Unfortunately, few banks have a large base of core deposits on which to draw. Moreover, those that once found it relatively easy to raise core deposits to fund their operations find it much harder today as investors have become more sophisticated and now seek out more profitable places to put their savings. As a result, most banks must rely more heavily on noncore deposits for funding. The greater volatility associated with these funds increases the rigor needed in a bank's liquidity management.
Besides increased use of noncore deposits, banks are relying on more non-deposit funding sources. An important and growing source of funds are loans (advances) from Federal Home Loan Banks (FHLB). These banks provide a wide array of credit products that banks can use to manage their liquidity positions.
Like owners of uninsured deposits, FHLBs are sensitive to the financial condition of the borrowing institutions. Although FHLB advances are fully collateralized and their collateral claim is superior to that of the FDIC and uninsured depositors-that is, they get the assets that collateralize their loans ahead of these other claimants in the event of failure—FHLBs are still mindful of borrowers' financial positions and will take action to reduce their loss exposure from borrower default. Because the FHLBs have access to all financial information regarding their borrowers, including bank examination reports, they quickly know about problems in an institution. Although there has been no known instance of a FHLB calling a loan, they have been known to limit institution's borrowing.
If your bank is using noncore funding such as brokered deposits or FHLB advances, here are a few commonsense tips.
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