New policy statement leaves key gaps—including in bottom line

By George Darling, Darling Consulting Group

Recently federal regulators released the final “Interagency Policy Statement on Funding and Liquidity Risk Management.” This policy statement emphasizes supervisory expectations for all federally insured depository institutions including banks, thrifts, and credit unions.

The statement carries implications for financial institutions of all types and sizes. Specifically, financial institutions will be expected to:

• Carry more on-balance sheet liquidity, in the form of readily marketable securities (i.e. U.S. Treasury and Agency Securities) and/or cash or cash equivalents as a “liquidity buffer.”

• Reduce reliance on off-balance sheet sources of funding, such as Federal Home Loan Bank (FHLB) borrowings and brokered CDs (i.e. wholesale funding).

• Develop and maintain Contingency Funding Plans (CFP) that include forecasts and stress tests of expected cash inflows and funding requirements.

• Ensure Board of Director oversight and monitoring of the liquidity management process.

• Ensure a fresh, outside perspective, by requiring that “an independent party regularly reviews and evaluates the various components of the institution’s liquidity management process.”

Now, let’s take a closer look at the policy statement and its implications. After that, I’ll share some concerns I have that you should consider as your bank implements and complies with the statement.

Policy overview

The new policy statement evolved as a result of recent events and the turmoil in the capital markets. These events revealed deficiencies at many financial institutions including:  “insufficient holdings of liquid assets, funding risky or illiquid asset portfolios with potentially volatile short-term liabilities; and a lack of meaningful cashflow projections and liquidity contingency plans.”


Liquidity and Liquidity Risk Defined

The policy statement defines liquidity and liquidity risk as follows:

Liquidity–“A financial institution’s capacity to meet its cash and collateral obligations at a reasonable cost.”

Liquidity risk—“A risk that an institution’s financial position or overall safety and soundness is adversely affected by an inability (or perceived inability) to meet its obligations.”
   
The policy statement outlines the key elements required to ensure a sound liquidity measurement and management process.

Key Elements for Managing Liquidity

There are numerous items detailed in the policy statement. Some of the key “take-aways” include the need for:

• Liquidity risk management to be fully integrated into an institution’s risk management processes.

• Effective corporate governance and oversight.

• Appropriate strategies, policies and procedures to manage and mitigate liquidity risk.

• Comprehensive measurement and monitoring systems.

• A diverse mix of funding sources.

• “Adequate” levels of highly liquid, unencumbered securities that can be used to meet liquidity needs in times of stress.

• Comprehensive contingency funding plans (CFP’s) that sufficiently address potential adverse liquidity events and emergency cash requirements.

The policy statement also contains guidance relating to appropriate corporate structure for measuring, monitoring and managing liquidity risk. It outlines:

• The roles of the board of directors and senior management.

• Reporting requirements and frequency.

• Policy content and suggested liquidity measures.

• The need for realistic collateral valuations.

• Requirements for stress testing.

• The need that “an independent party regularly reviews and evaluates the various components of the institution’s liquidity risk management process.”

Unintended consequences surface in statement

While the policy statement provides excellent guidance about the requirements for a comprehensive liquidity risk management process, it may result in some unintended consequences. These include reduced lending activities and more regulatory criticism about the use of loans as collateral for liquidity management.

Reduced lending activity could result from the need to provide more leverage capital to support additional, low-yielding, high-quality securities that institutions will be required to hold as an on-balance sheet liquidity buffer. For many financial institutions, already stressed capital ratios will be stretched further. This may result in fewer loans being originated in favor of securities.

The use of loans as collateral for liquidity management is conspicuous by its absence in the new policy statement.

Many institutions rely on access to the Federal Home Loan Bank System and/or the Federal Reserve Bank System to convert loans to cash as part of their operating and/or contingency liquidity planning.

Recent examinations have already provided anecdotal evidence of negative regulatory attitudes towards all types of wholesale funding. The absence of any recognition of loans as a funding source in the policy statement is somewhat disconcerting. It is unclear as to what level of acceptance this funding source will have with the regulatory agencies in future examinations as a result of omission in the policy statement.

Additional conclusions

The primary implications of the new policy statement will be the requirements for more robust liquidity measurements and management processes and the need to maintain higher levels of unencumbered, lower-yielding, highly liquid securities on the balance sheet. For many institutions, this guidance will require significantly more detailed cash- flow forecasting; improved collateral management; and expanded reporting.

The new guidance will, most likely, result in lower earnings for most financial institutions.

The combination of increased lower-yielding assets and additional operational expenses to improve the liquidity risk management process will probably be difficult to overcome in the current environment.

Additionally, there should be some concern over the fact that the use of loan collateral is not mentioned anywhere within the policy statement. The use of loans to secure funding has been, and will continue to be, an important source of liquidity for financial institutions.

About the author

George Darling is CEO of Darling Consulting Group, Newburyport, Mass. Darling and the consultants of his asset-liability management firm write the bankingexchange.com "ALCO Beat" column. Darling’s professional experience includes: thirty years with his own company, two years as a senior executive with a $2 billion financial institution, two years with a Big Five Accounting firm, and ten years with IBM. He is a nationally-recognized resource for assisting financial institutions in the areas of interest rate risk management, liquidity management, and capital planning.