- The ability to fund assets and meet obligations as they become due
- Liquidity Risk – risk of not being able to obtain funds at a reasonable price within a
reasonable time period to meet obligations as they become due
- Funds Management – involves estimating and satisfying liquidity needs in the most
cost-effective way without sacrificing income potential
- Liquidity should be measured on an ongoing basis
- Liquidity analysis involves:
- Analysis of current liquidity position
- Present and anticipated asset quality
- Present and future earnings capacity
- Historical funding requirements
- Anticipated future funding needs
- Options for reducing funding needs or obtaining additional funds
- Funds can be obtained through:
- Disposal of assets
- Increase in short-term borrowings and/or issuance of additional short-term deposit
and deposit like liabilities
- Increase in long-term liabilities
Liquidity Management
- Board approved written policies and procedures for day to day management
- Strategy and policy should be communicated throughout the bank
- Board should be regularly informed of liquidity position and should ensure
management monitors and controls liquidity risk
- Liquidity should be analyzed under various scenarios
- Contingency Plans
- Include strategies for handling liquidity crises and procedures for addressing cash
flow shortfalls in emergency situations
- Internal controls with regular independent reviews of management systems should be
- Concentrations in funding sources increases liquidity risk (bank should diversify)
- Two different situations requiring different planning
- Liquidity for ongoing operations
- Liquidity for unexpected demands
Board/Management Oversight
- Board should:
- Understand the nature and level of liquidity risk
- Establish tolerance levels for liquidity risk
- Approve policies
- Ensure management monitors liquidity risk
- Management should:
- Establish procedures, guidelines, internal controls, and limits
- Prepare contingency funding plan
- Review liquidity position
- Review strategies, policies, and procedures (to determine if still effective)
Policies and Procedures
- Establish asset/liability committee (define committee members, committee
responsibilities, how often committee meets, how to report to board, decision
- Periodic review of deposit structure (volume, trend, maturity, rates (competition
rates), public funds, out of area deposits)
- Policies and procedures (diversify funding options, acceptable funding sources)
- Method of computing cost of funds
- Investments permitted (diversify, pledging)
- Boards risk tolerance measured by ratios (liquidity, dependency, loan to deposit,
- Internal controls, independent review of liquidity management process
- Management and Board review of position and compliance with policies
- Contingency plan (establish LOC and test, alternative sources of funds)
- Measuring and monitoring position (cash flow projections)
- Approval procedures for exceptions to policies
- Tax planning
- Authority to access wholesale funding
Management Information Systems
Reports should contain basic information and be readily available for day to day liquidity
and funds management
- Reports should contain:
- Liquidity needs, sources of funds available, maturity distribution, expected
funding of commitments
- List of large depositors
- Asset yields, liability costs, net interest margin (track fluctuations)
- Exceptions to policy guidelines
- Economic conditions, interest rate projections, anticipated deviations from
- Volatile or higher cost funds histories (borrowings, broker deposits, public funds)
Internal Controls
Warning Indicators and Contingency Liquidity Plan
- Early warning signal include:
- Rapid asset growth funded by volatile liabilities
- Real or perceived negative publicity
- Decline in asset quality
- Decline in earnings performance or projections
- Downgrades or announcements of potential downgrades of credit rating
- Cancellation of loan commitments and/or not renewing maturing loans
- Collateral requirements increase on borrowings
- Correspondent banks decrease or eliminate borrowing lines
- Counterparties/brokers not willing to deal in unsecured or longer term
- Potential serious liquidity problems
- Turndowns in brokered markets
- Depositors request early withdrawal of money
Transaction sizes are decreasing and counterparties will not enter into short dated
- Increasing spread paid on deposits relative to local competitors (or national or
regional composites)
- Contingency plans should address alternative funding
- Plan helps ensure that a bank can prudently and efficiently manage routine and
extraordinary fluctuations in liquidity
- Plan helps management monitor liquidity risk, ensure that an appropriate amount of
liquid assets is maintained, measure and project funding requirements for different
scenarios, and manage access to funding sources
- Contingency plan should be:
- Updated regularly
- Define responsibilities
- Assess the potential for erosion under different scenarios
- Assess the potential liquidity risk for different liquidity sources (selling assets,
- Match potential sources and uses of funds
- Establish indicators that alert management to a predetermine level of potential
- Identify/create alternative funding sources
- Develop sequence in which to use funds
- Develop system to track liquidity and what is available for liquidity purposes
Funding Sources Assets
- Adjusting the price and availability of credit and the level of liquid assets held to
meet cash demands
- Assets normally assumed to be liquid sometimes are not liquidated easily or
- Holding to much liquidity can thin out profit margins
- If
- Sources of funds are stable
- Established yet unused borrowing capacity is significant, AND
- Loan demand is predictable
- A relatively low allowance for liquidity is required
- Need higher allowance for liquidity when:
- Competitive environment for deposits
- Trends show substantial reduction in large liability accounts
- Deposits are short-term and potentially volatile
- Loan portfolio consist of large problem credits
- Loan portfolio consist of non marketable loans (longer term, non homogeneous)
- High expectancy for unused lines to be drawn
- Close relationship between deposit accounts (individual and corporate) of
principal employers who are experiencing financial problems
- Significant portion of assets pledged to support wholesale borrowings
- Access to capital markets is impaired
Investment Portfolio
- Can provide liquidity through maturing securities, sale of securities for cash, pledging
securities as collateral
Asset Securitization
- Transformation of a pool of assets into cash
- Involves the transfer or sale of on-balance sheet assets to a third party who issues
asset backed securities that are sold to investors in the public debt market
- Investors are paid from the cash flow received from transferred assets
- Typically securitized assets include credit cards, automobile receivables, commercial
and residential mortgages, commercial loans, home equity loans, student loans
- Several risk associated with securitization
- Early amortization clauses (issued to protect investors, if issued bank must pay
principal to holders earlier than originally anticipated)
- Large concentration of residual assets (cash flow might be dependent on the
residual cash flows from performance of the underlying assets)
- Residual assets are illiquid assets and are not acceptable collateral to pledge for
- Market place reputation
- Loans held for sale funded with short term funding (problem if loans can not be
sold quick enough)
Loan Portfolio
- Loans can be used as collateral for secured borrowings or sold for cash in the
secondary loan market
Loan Commitments
Funding Sources Liabilities
Alternative to using assets to satisfy liquidity needs
- Which strategy to use (asset or liability) should be dependent on costs,
concentrations, and management’s expertise
- Management should project deposit growth, determine make-up of the accounts as to
stable, fluctuating or seasonal, and volatile deposits
Core Deposits
- Sum of demand deposits, NOW and ATS accounts, MMDA savings, other savings,
time deposits under $100M.
- Core is generally stable, lower cost funding sources
- Typically funds of local customers that also have a borrowing or other relationship
with the institution are also core
- Deposits that are typically considered volatile can be core (need to monitor to
Public Funds
- Deposit accounts of public bodies such as state or local municipalities
- Must be secured
- Typically fluctuate on a seasonal basis
- Can be reasonably stable over time or fluctuations are predictable
- Bid types are usually less stable
Large Depositors
- Funds under one control, or payable to one entity, which aggregate 2% or more of the
bank’s total deposits
- Potentially volatile, but can be stable (must monitor over time)
Negotiable CDs
- Usually issued by money centers or large regional banks in denominations of
$1,000M or more and may be issued at face value with a stated rate of interest or at a
discount similar to US Treasuries
- CDs of major banks are widely traded and may offer substantial liquidity
- Negotiable CDs are used to fund reinvestment goals of issuing banks as opposed to
solving liquidity crises
- Negotiable CDs are a form of purchased funds
Brokered and Rate Sensitive Deposits
- Customers who focus exclusively on yield are highly rate sensitive and are less stable
funding sources (Customers may have no other relationship with the bank)
- Deposit brokers are not regulated by bank regulatory agencies
- Brokered Deposits – any deposit that is obtained from or through the mediation or
assistance of a deposit broker. For insured banks that are not well capitalized,
brokered deposits include any deposit solicited by offering rates that significantly
exceed market rates.
- Broker deposits are highly volatile and carry higher interest rates than alternative
sources of funds
- Part 337 – limits the use of brokered deposits
- Undercapitalized – bank may not accept, renew, or roll over any brokered deposit
- Adequately capitalized – banks may not accept, renew, or roll over any brokered
deposit unless the bank has applied for and been granted an application waiver by
the FDIC
- Well capitalized – the only banks allowed to solicit and accept, renew, or roll over
any brokered deposit without restriction
- No stigma should be attached to the acceptance of brokered deposits and the proper
use of such deposits should not be discouraged
- Any loans tied to specific brokered deposits should receive special scrutiny
Secured and Preferred Deposits
- Secured and preferred deposits impose pledging requirements upon banks
- US government securities are the most commonly pledged
Bank Investment Contracts
- A deposit contract between a bank and its customer that permits the customer to
deposit funds over a period of time and obligates the bank to repay the amounts
deposited plus interest at a guaranteed rate to the end of the contract term (term can
be from 6 months to ten years)
- Typically not transferable or sellable in the secondary market
- (Deferred compensation plans, employee benefit plans)
International Funding Sources
Federal Funds Purchased
- Transactions of overnight or over-the-weekend unsecured transfers of immediately
available funds between banks
Treasury Tax and Loan Accounts
- Banks receiving TT&L funds have the option of either remitting daily (remittance
option) or maintaining the funds in an interest bearing, demand account (note option)
- Note option permits banks to retain the TT&L funds as secured, purchased funds
callable on demand
- Note options funds should be shown as Other Borrowed Money for the Call Report
- Borrowings can be tailored/matched to assets
- Locking in term funding can reduce liquidity risk
- Borrowing funds should never automatically draw criticism
- Borrowings should be a supplemental funding source, rather than as a replacement for
core deposits
- Banks must be a member to borrow
- Most advances require collateral
- Many different types of advances are offered by the FHLB
- FHLB advances are credit sensitive
- FHLB reviews customers credit risk profile on an ongoing basis
- If credit risk profile declines to a level where the FHLB begins to restrict further
borrowing, the bank will suffer the effects of increased collateral requirements or
reduced borrowing flexibility when it may be needed most
- When the credit risk profile increases, the FHLB may:
- Refuse to renew advances upon maturity
- Accelerate repayment of advances due to a covenant breach
- Raise collateral requirements, OR
- Reduce funding lines
Repurchase Agreements
- A bank agrees to sell a security to a counter-party and simultaneously commits to
repurchase the security (the same security at the same price with interest) at a
mutually agreed upon future date
- Repos are a form of secured borrowing
- Most repos are day-to-day (overnight), but terms of up to one to two years are not
- If the repurchase agreement requires the selling bank to repurchase the identical asset
sold, then, generally the bank has retain control over the future economic benefits and
should report the transaction as a borrowing.
- If the it is not required that the bank repurchase the identical security sold, the
agreement is reported as a sale of the securities and a commitment to purchase
- Reverse Repurchase Agreement – if the agreement requires the buying
bank/individual to sell back the identical asset purchased, the agreement is treated as
a loan. If it is not required to sell back the identical asset, the agreement is treated as
a security purchase and a commitment to sell securities
Dollar Repurchase Agreements
- Require the buyer to return to the seller substantially similar, versus identical,
To qualify as borrowings, dollar repos must require the buyer to return to the seller
substantially similar securities by the settlement date (which cannot exceed 12
months from the inception of the transaction)
- Mortgage pass through securities repurchased are considered substantially similar
- Collateralized by similar mortgages,
- Issued by the same agency and be part of the same program
- Have the same remaining weighted average maturity
- Be priced to have similar market yields
- Have identical coupon rates
- Satisfy good delivery requirements
- Securities used in dollar repo transactions much have been held in the seller’s
investment portfolio for a minimum of 35 consecutive days prior to the initiation of
the contract
Federal Reserve Bank
- FRB requires collateral for borrowings
- Types of credit extended at the discount window:
- Adjustment credit – overnight credit to meet temporary liquidity needs
- Seasonal credit – assist small institutions that lack effective access to national
money markets
- Extended credit – in exceptional circumstances for institutions under liquidity
- Emergency credit – rare circumstances
- FRB borrowings is available for unusual needs and is not a source to fund ongoing
- Possible reasons for borrowing include:
- Preventing overnight overdrafts
- Loss of deposits or borrowed funds
- Unexpected loan demand
- Liquidity and cash flow needs
- Operational or computer problems
- Tightened Fed Funds market
- Non viable banks are not allow to borrow from the discount window
- Advances not to exceed 60 days in any 120 day period for undercapitalized banks
(this limit may be overridden by the bank’s regulatory rating agency or the FRB
Chairman certifies in writing that the borrower is viable. Certifications may be
renewed for an additional 60-day period)
Bank Holding Company
Trust Preferred Securities
- Hybrid instruments that are generally considered debt securities when purchased by
banks as investments, but have equity characteristics as the Federal Reserve allows
their inclusion to a maximum of 25% of Tier 1 capital for the issuer, a BHC
- Long term nature
- Cash raised from the BHC selling TPs is often downstreamed to the bank, should be
viewed as a capital injection rather than as a funding source for ongoing operations
Role of Equity in Evaluating Liquidity
- Issuing new equity is a slow and costly way to raise funds (should not be viewed as
an immediate or direct source of liquidity)
Commercial Paper
- Short-tern, negotiable promissory note, issued for short-term funding needs
- Usually matures in 270 days or less
- Not collateralized
- Purchased by institutional investors
Examination Treatment
- Liquidity component should be assigned in the context of other financial factors
- Ratings
- 1 – strong levels, well developed management, sufficient sources favorable terms
- 2 – satisfactory levels, sufficient sources acceptable terms, modest weaknesses
- 3 – need improvement, lack ready access, significant weaknesses
- 4 – deficient levels, inadequate management, not have or not able to obtain
sufficient sources/volume
- 5 – critically deficient, viability threaten, external assistance needed
- Ratings should be based on:
- Volatility of deposits
- Reliance on interest sensitive funds
- Frequency and level of borrowings
- Unused borrowing capacity
- Capability of management
- Level of diversification
- Ability to securitize
- Availability of assets readily convertible into cash
- Ability to pledge assets
- Impact of holding company and affiliates
- Access to money markets
- Banks earnings performance
- Banks capital position
- Credit commitments
- Rating should be based on average liquidity over a specific period as well as liquidity
position on a particular date