Allen North's article, "Arkansas Bank Failure Teaches Lessons in Missed Fundamentals," in this issue of Central Banker points out the challenges of managing bank liquidity when asset quality issues arise.
Section 38 of the Federal Deposit Insurance Act requires insured depository institutions and federal banking regulators to take "prompt corrective action" to resolve capital deficiencies at insured depository institutions. What are the relevant prompt corrective action provisions that can affect liquidity, and what should a bank's board of directors consider when setting a bank's liquidity tolerances? Key provisions for different capital categories include the following:
Such institutions must receive a waiver from the FDIC to accept, renew or roll over brokered deposits (banks sell these large-denomination deposits to brokerages). A waiver is granted on a case-by-case basis, upon a finding that acceptance of such deposits does not constitute an unsafe and unsound practice.
If granted, an institution may not pay an effective yield that exceeds by more than 75 basis points the effective yield paid on deposits of comparable size and maturity.
Institutions that are undercapitalized to varying degrees must take additional actions and have additional requirements:
In addition, within 90 days of the bank becoming critically undercapitalized the chartering authority must:
What does this all mean? As capital ratios deteriorate, the ability to generate high-rate deposits can become restricted. Moreover, Section 142 of the Federal Deposit Insurance Act places limits on Federal Reserve discount window lending in these situations.
The best solution to liquidity strains during times of financial stress is to prevent them. Therefore, boards of directors should consider:
|Capital Category||Total Risk-based||Tier 1 Risk-based||Leverage||Other|
|Well-capitalized||10% or more||6% or more||5% or more||not subject to formal action to maintain a specific capital level|
|Adequately capitalized||8% or more||4% or more||4% or more||leverage ratio of 3% or more if bank is 1 rated and not growing|
|Undercapitalized||less than 8%||less than 4%||less than 4%||leverage ratio of 3% or more if bank is 1 rated and not growing|
|Significantly undercapitalized||less than 6%||less than 3%||less than 3%||N/A|
|Critically undercapitalized||N/A||N/A||N/A||tangible equity to total assets ratio of 2% or less|
SOURCE: Section 38 of the Federal Deposit Insurance Act