Loan-to-deposit ratios have been rising at Wisconsin banks, and in today's economic environment that is drawing regulatory attention. "As of June 30, the total of loans in our commercial banks divided by the total of deposits reached over 90 percent," said Timothy M. Sinz, financial examiner supervisor, Wisconsin Department of Financial Institutions. "That's been climbing quite a bit over the last few years, and it shows that we're not seeing as much liquidity on our banks' books." In some instances, this decrease could be due to lack of practice. "Interest rates rising is forcing CFOs to flex muscles they haven't flexed in a while," explained Kyle Manny, CPA, CGMA, senior manager of financial institutions, Plante Moran. "They've been focused on managing asset quality issues for a long time, but liquidity management is one of the most important components of their jobs." With rates rising, bank management must return their focus to liquidity risk management, and while regulatory requirements are a good starting point, it's important to move beyond them in order to reap the benefits of effective, tailored liquidity risk management. "If you do a good job of the business and risk management aspect of liquidity, the compliance part will likely fall into place," said Thomas Danielson, CPA, principal – financial institutions at CliftonLarsonAllen LLP.
"Liquidity and funds management doesn't exist in a vacuum," Danielson explained. "Best practices for liquidity management start with strategic planning and budgeting for the next year so there's a balance between asset growth, specifically loan growth, and the ability to fund that growth in a cost-effective manner without undue reliance on nontraditional funding sources." Understanding the bank's individual liquidity profile—as well as its core deposit base—and building thoughtful liquidity policy limits based on that is a key step to effective liquidity risk management, according to Manny. "Understanding your core deposits is the best way to understand your liquidity risk profile," he advised, explaining that banks should routinely determine which depositors are stable funding rather than solely defer to the UBPR definition of core deposits (based on the Call Report classifications). For example, CDs exceeding $250,000 that have been with the bank a decade or more likely could be appropriately considered core deposits as you consider your individual liquidity risk profile, while new money market accounts brought in via high-cost "specials" may not be.
3 Key Risks and How to Address Them
Since the financial crisis, banks and regulators have both focused more on liquidity risk, but finding the balance between maintaining sufficient on balance sheet liquidity and reducing it in exchange for better yields is a difficult one for many institutions. "We've been seeing reductions in on balance sheet liquidity in banks, in general," said Sinz. "I wouldn't say it's across the board yet, but we have seen some banks trying to chase yields going to longer-term bond issues, which raises some concerns from a liquidity standpoint as to how useful those bonds might be in the future if interest rates continue to rise." The simplest solution—to acquire and retain more core deposits—is also very difficult in today's competitive rate environment.
Another challenge with addressing liquidity risk is how to prepare for stress events such as unexpected deposit runoff or loan opportunities. "Have contingency plans as to what you would hope to do to address liquidity events," Sinz advised. "Laying out plans for how you'll address those types of events, and two or three times per year taking those events and stress testing them with your current balance sheet." For most banks, that means having multiple sources of funding to draw from, including purchased Fed Funds, borrowing from the FHLB, and using purchase agreements, brokered funds, and internet listing services. Many institutions would benefit from going a step further and actually drawing on those noncore funds, Danielson says. "Periodically use each of those services, even if it's just for borrowing money overnight," he suggested. "That way you know how to actually access the funds when you need them."
Of course, concentrations in funding sources outside of core deposits can also present significant liquidity risk, should those sources dry up; as Danielson pointed out, when you need liquidity the most is also when it's hardest to get. "Banks are going more significantly into using FHLB borrowings and also using brokered CDs or listing service CDs in their funding," said Sinz. "What that tends to lead to, is we see a significant number of banks having funding concentrations from non-core—and potentially more volatile—funding sources." One effective way to mitigate that risk (beyond rebalancing the concentrations) is to tailor the bank's liquidity risk profile to the other bank strategies. "Make sure that if your primary contingent funding source is the sale of unencumbered investments, it is reflected in the types and duration of investments purchased," Manny explained. "You need to be willing to sell at the prices the market will bear."
Reviewing Your Risk Management System
When it comes to gauging the effectiveness of the bank's liquidity management system, periodic review is critical. "Sometimes bankers treat liquidity management a bit like plumbing… they only pay attention to it when it doesn't work," Danielson pointed out. He recommends reviewing the whole system on a regular basis—including policies, procedures, and internal controls—to make sure it's up to date and functioning as planned. That review should factor in the bank's unique balance sheet makeup and business strategy, as well. For example, contingency funding stress tests are required, but utilizing the most common scenarios—such as a five percent decline in deposits—is not always the most effective testing strategy. "Those stress scenarios should be tailored to your institution's balance sheet," said Manny. "Cookie-cutter is not what examiners are looking for here."
Two other good measures of the effectiveness of a bank's liquidity management system are the non-core dependency ratio and loans to core deposits ratio (among others). "The higher the non-core dependency ratio is, the greater chance you don't have similar terms between the asset and its funding," Sinz explained. Since core deposits are less likely to leave during tough times, the loan to core deposit ratio provides a good view of the stability of the bank's deposits, according to Danielson. "The most stable funding a bank has is its local customers, which roughly translates into core deposits," he explained. "Loan to total deposits doesn't capture that component nearly as well as the loans to core deposits ratio."
Finally, every effective liquidity management system must involve consistent, clear communication, especially during stress events. "Boards, and CEOs in particular, should periodically hear about stress events that happen," Manny advised. "If whoever is charged with monitoring liquidity is the only one who knows about it, that's a problem. A lack of communication about the event and how it was addressed could be a red flag." Clear reporting of policy limits and contingency funding sources to the Board of Directors is also essential to effective liquidity risk management. "Once you've gone through the process of tailoring your policy limits and contingency funding plans, make sure you report clearly to the Board instances when the plan was initiated," Manny said.
Sidebar: Regulatory Updates
As a starting point, banks should be familiar with the Interagency Policy Statement on Funding and Liquidity Risk Management, published in 2010. "That document lays out what the expectations are for banks to be doing regarding funding and liquidity risk management," said Sinz. However, two recent updates will make liquidity compliance a bit easier for banks to manage:
- A change in state statute now allows the FHLB to provide a letter of credit that the bank can use for municipal deposits above their insurance level, which also frees up securities that they may have pledged previously to municipalities.
- New legislation and anticipated new regulatory rulemaking from federal agencies will change the treatment of reciprocal deposits, such as CDARs, so that they're no longer considered to be brokered deposits (up to certain limits).
Plante Moran is a WBA Silver Associate Member.
CliftonLarsonAllen LLP is a WBA Bronze Associate Member.