As the economy changes, so does the banking industry’s approach to interest rate risk management. During the Great Recession, loan demand weakened and investment yields did not seem to offer a compelling alternative to cash. Furthermore, bank customers were not attracted to risk assets so they gravitated toward cash, leaving banks with excess liquidity. As the economic recovery continues, we have started to see liquidity levels decline as loan-to-deposit levels approach 100 percent in many community banks.
A review of historical call report information shows that when Fed funds rates increase more than 150 basis points, bank liquidity levels tend to decline by 30 to 50 percent. For the bank that has been operating at 15 percent primary liquidity levels and is now at 10 percent, this is not a significant game changer. But it is time to put liquidity management on the radar screen. Those banks with liquidity levels moving from 10 percent to 5 percent and below will need to ensure that they have strong risk management policies, procedures and processes to manage funds with a tighter margin of error.
Regulators are quite aware of cyclical ebbs and flows in liquidity. They have been voicing concerns for several years now. For this cycle, liquidity will likely be more of a significant issue as three factors differentiate this cycle. First, depositors are hungry for yield, creating competition from money market funds as rates rise. Second, nonbanks in the fintech sector are gaining momentum by the day and are also beginning to attract deposits. Lastly, we have reached a time where people can conduct all of their financial business without entering a retail bank. If you add these three factors to a typical liquidity cycle, you get the recipe for a perfect liquidity storm.
Liquidity management policies, like interest rate risk and credit risk management policies, take some effort to change. While you can rewrite a policy in one day, the risk management processes take time and experience to implement. This is especially true if an institution is utilizing wholesale funding, which requires time to establish and test, and then experience to manage properly. If any tertiary sources of liquidity may be utilized, such as loan sales or asset securitization, the viability of those should be evaluated in detail.
The best place to begin is to review the actual liquidity calculation and forecast. Then ask two questions. First, are these calculations and frequency consistent with the way liquidity is actually managed? Second, are these calculations consistent with the direction of the overall risk levels? The answer to question number one is often surprising. It is not all that uncommon for a bank to report a ratio or two to management and yet have a completely different set of metrics that actually manage their organization’s liquidity. Since managing liquidity interrelates with other risk sectors, these measurements should be uniform and reported accurately on a regular interval. Question number two is often overlooked because banks tend to manage liquidity for the near term, meaning the next 30 to 90 days. This is important, but a longer dynamic simulation should be implemented to understand how a bank will fund its overall balance sheet growth. In addition to a growth simulation, the bank should understand how the next 36 months will impact its overall long-term liquidity position. Once these questions are answered, management can start to build a comprehensive process that includes all potential liquidity sources both on and off the balance sheet.
After the liquidity processes and calculations have been updated, the next focus should be the policy. The policy limits should be prudent and consistent with management practices. If liquidity is not included in the overall asset liability committee funds management policy, then care should be taken since those often interrelate. Finally, the contingency funding plan (CFP) should be considered since it is an integral part of liquidity management. For institutions that optimize liquidity, the CFP is an entire subject of its own merit.
It is a good idea to test many management practices. This is especially true for liquidity. Simply documenting that you can use a liquidity source is not good enough. All primary and secondary liquidity sources should be tested on a regular basis. If a source is too expensive to test or takes longer to execute, it should be considered a tertiary liquidity source. The testing of liquidity sources should be documented in ALCO.
Liquidity management practices will continue to be a regulatory focus over the next few years as rates rise, loan demand increases, depositors become hungry for yield, and customers have more options. Simply reporting a quarterly number to management will not be adequate. Now is the time to closely examine the bank’s overall liquidity management process to prepare for the future.