Liquidity: A Balancing Act in a Changing Landscape
By: Ed Spielbusch, Regional Manager - Southeast Region
Liquidity is basically defined as the ability to fund assets and meet obligations as they come due. Financial institutions must have the ability to meet expected and unexpected cash demands from their customers, and potential customers, to function profitably, and maintain confidence in the banking system. However, cost is the part of the liquidity equation that is sometimes not fully factored in when discussions of pure liquidity arise. Banks must not only have access to funding sources, but need access to reasonably priced funding sources that lead to reasonable profits. In the simplest of times, almost all bank liquidity was provided by local customers who loaned their funds to the bank in the form of deposit accounts for a return. The bank would in turn employ these funds by purchasing investments or making loans. As a result, liquidity was easily measurable and was entirely contained within the "balance sheet" of the bank. Banks would maintain liquid balance sheet assets such as cash, due from banks, Federal funds sold, and a laddered investment portfolio. The first three categories provided immediate cash, with the laddered investment portfolio spinning off ongoing additional funding. Oh, what simple times; easily understood, easily managed, easily measured, and generally cost effective.
Now, banks are finding themselves with a myriad of non-core choices to meet their funding needs. Most prevalent of these contingent sources of liquidity is the ability to extract cash from their loan portfolio through borrowing from the Federal Home Loan Bank (FHLB). The bank pledges loans to a borrowing line from the FHLB, which depending on type, receive varying loan values. Of course, the bank must own stock in the FHLB and are bound by other limitations such as collateral. FHLB advances are available in varying products from lines-of-credit to various types of short-term, intermediate, and long-term advances under different pricing and repayment structures. Other sources of liquidity include extracting funds from the securities portfolio, such as substituting deposit insurance for pledged securities on public funds and selling repurchase agreements. A bank can also sell participations in loans, borrow from correspondent banks, utilize a Treasury Tax and Loan (TT&L) note option, or utilize the Federal Reserve discount window. In addition, advances in technology allow for the acquisition of funds through the internet, allowing a bank to theoretically acquire funds from the world. In addition, bank's can also acquire funds through brokers in the form of brokered deposits. However, in utilizing these funding sources, management must keep in mind part two of the liquidity equation, which is the acquisition of funding sources at a reasonable cost. More and more in today's economic environment, small banks in rural settings are finding themselves with dwindling core deposit bases which must be replaced in some manner. Couple this with the desire for some of these entities to attain growth and a higher reliance on non-traditional, non-core funding has developed. However, as a time tested saying of sage advice I recall states, "All things in moderation."
Managing liquidity in the simplest of times essentially required limited management. Banks seemed to fall within a certain balance and were bound by the restraints of their local economies, before the advent of branch banking, the internet, the FHLB, deposit insurance, and other vehicles for creating funds. Now, banking is more competitive than ever with numerous competitors chipping away at the core that individual banks enjoyed for so long. As a result, liquidity management, and the understanding of sources and uses of funds, coupled with the cost/return equation, requires constant management. Boards should develop strong investment and funds management policies along with tools to measure ongoing liquidity. Stagnant liquidity measurement tools are probably a thing of the past and should be replaced with cash flow and profit analysis under varying funding sources. Care should be taken to not make the institution so reliant on non-traditional funding sources that they are backed into a corner where the funds have to be obtained at any cost, eroding spreads and profitability. In addition, a sufficient number of contingent sources should always be maintained as an "emergency" fund, so to speak. Lastly, it becomes very easy for balance sheet mismatches to develop, leading to interest rate risk, with short-term borrowings funding long-term assets. Liquidity is just one more aspect of banking that must be managed and monitored closer in an increasingly complicated world.
Liquidity is obviously one of the six components rated at examinations, being the "L" in the CAMELS rating system. Examiners, as always, will be scrutinizing the level and sources of your liquidity at your next examination. Examiners will measure the level of your balance sheet liquidity, look at the timing of that liquidity, look at your contingent sources of liquidity, your dependence on non-traditional funding sources, the funding commitments you have, and their likelihood of coming to fruition. In addition, the degree of mismatches such as the use of volatile liabilities and non-traditional funding sources to support long term assets (i.e. Dependency Ratio) will also be measured. Managerial oversight, measurement, and policy parameters for funds management will also be assessed.
