ByTimothy A. Bosch , Gary S. Corner
The current financial environment has drawn bankers’ attention to an often forgotten component of the CAMELS rating: the “L” component, liquidity. Management of liquidity has become a challenge for many banks experiencing asset quality issues. In some cases, the inability to cover maturing deposit outflows can cause a bank to fail.
Locally generated FDIC-insured deposits have historically been a stable source of funds for banks. Unfortunately, over the past decade stable core deposits have declined as a percentage of most banks’ liabilities. Banks now rely on many other sources of funds that are not as stable, including high-rate deposits, Federal Home Loan Bank advances, fed funds purchases and brokered deposits.
If your bank depends significantly on non-core deposit funding, then it is important to “stress test” liquidity and contingency liquidity sources. Here are a few common-sense questions to get started:
Your liquidity position is best estimated as a flow of funds over multiple time periods. In other words, measure expected cash inflows and outflows in near-, medium- and longer-term periods. A simplified analysis might include elements in the PDF linked above right.
This analysis can be conducted under multiple scenarios, ranging from normal operations to broad, systemic disruptions. The point of stress scenarios is to identify liquidity vulnerabilities and to identify appropriate contingency funding sources well in advance of the need.
This depends on your liquidity risk profile. At a minimum, we suggest two scenarios: a normal state and one with your bank undergoing a specific stress state. If your bank is exposed to significant asset quality issues, we suggest more scenarios. As discussed later, liquidity sources that are dependable in good times often disappear when the balance sheet becomes distressed.
When an institution is designated “undercapitalized” for prompt corrective action purposes, it must receive a waiver from the FDIC to accept, renew or roll brokered funds. Moreover, the rate paid on deposits may not exceed 75 basis points over the local market rate. This creates an important stress scenario that cannot be overlooked.
When a borrower’s financial condition begins to deteriorate, any lender may take steps to reduce a possible loss on the loan, such as require additional collateral, reduce the available line or call the loan. If you rely significantly on FHLB advances, consider a reduction in the line as another scenario to test.
Setting up a borrowing relationship and pledging collateral to the discount window is a sensible component of a contingency liquidity plan. Discount window credit is then available when unexpected events occur. Note, however, that federal law limits the Federal Reserve’s ability to provide discount window credit to undercapitalized and critically undercapitalized institutions.
Your bank regulator expects you to adopt a well-thought out policy and implement commensurate practices to control liquidity risk. Having a realistic, tested, contingency funding plan is essential to weather today’s volatile financial environment.