Menu
Banking Exchange Home
Menu

Don’t let rate worries hide liquidity risks

Good ALM requires dual view

Don’t let rate worries hide liquidity risks

By Joe Kennerson, manager of client services, Darling Consulting Group

Focus in asset-liability management centers on interest rate risk (IRR), as the banking industry composes its playbook for rising rates. The Fed’s announcement about rates this week merely put more urgency into that focus.

Yet that concentration on interest rate risk, in conjunction with the current abundance of liquidity flowing through the system, may be overshadowing the importance of developing a strong contingency funding plan.

The result could be an unconscious move of liquidity management to the back of the rising rate playbook—as far as the appendix.

Not so fast.

The next rate cycle will impact liquidity as well as rate risk.

Having a robust contingency funding plan can help prepare bank managers for a tighter liquidity position when rates rise, while also strengthening overall liquidity management.

A sound contingency funding plan should be built from the following elements.

The Plan, core of liquidity protection

Every bank should maintain a written “CFP” that identifies roles and responsibilities of a liquidity “task force” so the bank can proactively manage a liquidity crisis should one occur. A well-structured CFP should identify early warning indicators that can “trigger” potential liquidity stress, assess risk severity, and establish a response plan to preempt a liquidity crisis.

For example, how would the bank react if credit lines are shut off and there is a “run” on deposits? If one answer is to raise deposits in the national market, then be sure that this funding source is documented within the policy—and is tested at least annually.

Cash flow forecast forms foundation

All asset-liability management committee should be able to answer: “How much liquidity do we have and how much liquidity will we need?”

Establish this by developing a forward-looking cash flow analysis that incorporates growth projections either through the budget or current loan and deposit forecasts. The forecast will determine the potential for a cash surplus or deficit over a one-to-two-year time horizon.

Then analyze all capacities to access wholesale funding (FHLB, brokered deposits, Fed funds lines, FRB, national deposits, etc.) in the event of a funding shortfall.

A best practice approach would incorporate how key funding metrics would be affected relative to policy guidelines (e.g. on-balance sheet liquidity, wholesale funding reliance, loan/asset ratio, etc.).

Stress testing isn’t just for rate risk anymore

Once a baseline scenario is established, the next step is to stress test the strength of the bank’s liquidity position. Stress testing identifies potential weaknesses such as concentrations of large deposit balances or reliance on secondary sources of funding (e.g. brokered deposits).

Stress tests should focus on key elements that would cause severe liquidity stress. Scenarios can be systemic (i.e. national credit crisis) or, more specifically, linked to the bank (i.e. largest local employer closes business).

Analyze how liquidity holds up over time when the bank is faced with deposit runoff, increased collateral haircuts, and loss of funding lines. Utilize the bank’s most recent deposit study or research historical “deposit runs” that may have happened to other banks in your marketplace for ideas on how much deposit volatility should be modeled.

Now examine varying levels of stress to identify how the bank can withstand different magnitudes of a liquidity crisis. For example, a 10% runoff in deposits over the next year may not lead to an illiquid state, but how does the bank hold up against 15% or 20% deposit runoff? How do these volatility measures match up relative to the results of your most recent deposit study?

Find weak spots, then find the solution

Extreme stress tests can identify what has to happen for the bank to run out of cash. The next step is to use the plan to outline strategies to get through the liquidity crisis.

In other words, if cash needs to be raised in a pinch, how would it be done?

If the bank is less than well-capitalized and has limited access to wholesale funding, then the plan may be to raise deposits by offering a CD special. However, be sure to understand the FDIC rate restrictions that cap deposit rates for banks that fall below well-capitalized, which are based on a spread to national averages. (The 12-month CD rate cap was 0.95% as of March 10.)

Take the next steps and model possible “relief” scenarios to give the asset-liability management committee and examiners comfort that management has an established plan to navigate through a liquidity crisis.

Risk monitoring: Your early warning line

The goal of establishing a CFP is to anticipate a liquidity crisis before it happens. That’s the job of a Risk Monitor. Develop bank-specific early warning indicators that will track both qualitative (e.g., are we operating under a regulatory order?) and quantitative measures (e.g. delinquency ratios). Each indicator should be assigned “trigger” levels of green,  yellow, or red that signal progressively elevated risk. Trigger levels should be reflective of historical trends, the bank’s business model, and policy guidelines.

Written responses to a “triggered” early warning indicator can help boards and examiners understand why an indicator has been triggered and whether management needs to create an action plan.

Preparing for rising rates’ liquidity impact

The abovementioned contingency plan components should be a part of every bank’s liquidity management process, and updated at least quarterly. As anticipation for rising rates builds, banks should also be running stress tests that examine the potential impact on liquidity if rates rise.

The following elements should be addressed:

Potential deposit volatility. One of the most focused discussion items in ALCOs today is the potential for disintermediation within non-maturity deposits, including such instruments as checking, savings, and money market accounts. Many banks have utilized studies of these deposits to obtain a better understanding of this potential volatility, as well as take “deeper dives” into deposit concentrations and trends over the past 5-10 years. Results from the studies can then be integrated into a liquidity stress test to examine the impact of runoff of volatile deposits if rates rise.

Reduced bond collateral. The backup in rates in 2013 had a significant negative impact on the market values for most bond portfolios. What could be the cause for another 100, 200, or 300 basis point movement in rates? Determine the potential decrease in value of the bond portfolio if rates rise and the impact of declining collateral levels. This is particularly important for banks that have high pledging requirements for secured liabilities (e.g. public funds, sweeps and borrowings).

Loan growth. Most banks would warmly welcome a pickup in loan demand, and a stronger economic environment could lead to just that. Examine the impact on liquidity if loan projections double or triple, coupled with the aforementioned deposit runoff—resulting in a wide funding gap. Are wholesale funding lines and policies in place to work through such a scenario?

Looking forward

A well-developed CFP with a forward-looking, cashflow forecast will help strengthen overall liquidity management. Focus should not be lost on liquidity stress testing - even given the abundance of liquidity in the banking industry today.

Start preparing for the next rate cycle by examining the impact on cash availability when—not if—deposits leave the bank, bond collateral values decline, and loan demand strengthens—and keep liquidity in the forefront of your playbook for rising rates.

About the author

Joe Kennerson is manager of client services at Darling Consulting Group. In this capacity, he works with financial institutions to help provide solutions for the asset-liability management process in the areas of interest rate risk, liquidity risk management, ALM modeling, regulatory compliance, and executive level education. Kennerson oversees the firm’s contingency liquidity model, Liquidity360, for over 200 institutions.

ALCO Beat

ALCO Beat articles featured exclusively on bankingexchange.com are written by the asset-liability management experts at Darling Consulting Group. Individual authors' credentials appear with their articles. DCG's consultants have served the banking industry for more than 30 years. You can read more about the firm's history here.

back to top

Sections

About Us

Connect With Us

Resources