Anyone involved with community banking in recent years has witnessed distinct changes in the way depository institutions fund their asset growth. In particular, there has been a steady increase in alternative sources of wholesale funding available to bank managers. As core deposits dropped relative to total assets, bankers recognized that managing liquidity was not as easy as it once was, and therefore increased reliance on brokered CDs, FHLB advances and other wholesale sources to fund the extension of credit.
These liquidity sources were originally considered secondary or contingency funding alternatives, but eventually became primary or operational sources of liquidity as competition and growth pressures persisted. Meanwhile, the investment portfolio, traditionally a store for liquidity and safety, has in some banks become burdened with highly illiquid securities. That is something the regulatory authorities have mentioned specifically in the wake of recent financial market turmoil.
At the end of June, a joint statement on proposed liquidity guidance was issued by the banking agencies. This proposed guidance focuses on many key elements already addressed by the individual agencies. Among other things, the statement targets a need for banks to reduce reliance on liability-based funding strategies, and instead to improve the functioning of asset-based funding. This requires having “adequate levels of highly liquid marketable securities … that can be used to meet liquidity needs in stressful situations.” Additionally, institutions should use cash flow analysis to monitor their liquidity exposures and should have contingency funding plans. The proposed guidance discusses a need for increased oversight by directors regarding risk management processes as well.
Investments and Liquidity
To use the investment portfolio as a tool for managing interest rate risk in the balance sheet, use highly marketable bonds such as those backed by the U.S. treasury or government-sponsored enterprises. Baker Group clients have benefited from this and have avoided the pitfalls of banks that were sold securities such as non-agency CMOs, CDOs, trust-preferred securities and preferred stocks. Those securities are now an enormous burden in terms of illiquidity and the unpleasant effects of serious price deterioration. The economic cost of locking up the balance sheet and precious capital on illiquid assets can easily outweigh whatever interest and cash flow is being received.
In addition to marketability, proper identification of bonds and bond-types that provide reasonably consistent and predictable cash flow is critical. The risk/reward relationship for securities should be viewed with an eye toward liquidity risk. When purchasing a bond or considering alternatives, portfolio managers should take a hard look at the cash flow uncertainty or optionality as well as the underlying price sensitivity.
On any given day, the bond portfolio may receive interest payments or principal payments from matured bonds, call features or prepayments. Some portfolios have well-defined cash flows because they consist of simple bullet bonds that pay semiannual interest payments and return principal in one lump sum on the stated maturity date. These portfolios don’t always offer much in terms of relative yield, but they are easy to manage. Most bond portfolios, however, are much more dynamic and require constant cash flow analysis.
Pro-Forma Cash Flow Analysis
Banks should have dynamic tools for monitoring investment cash flows across a variety of scenarios. Projected cash flows under the existing rate environment are a necessary starting point, but must be supplemented by additional projections for different rate scenarios. We know that portfolios that contain callable bonds or MBS will experience faster cash flows when rates fall and slower cash flows when rates rise. This asymmetry of cash flows and the degree to which those cash flows are uncertain needs to be calculated and reflected in an analytic reporting model.
It is equally important to understand that the degree of price sensitivity tends to vary directly with the degree of cash flow uncertainty. In other words, if cash flows are uncertain and variable, then the underlying value of the portfolio will be similarly uncertain and variable. A portfolio consisting entirely of bullet bonds will have a level of price sensitivity or duration that is more or less constant and predictable. It may be high or low, but it will not experience much variation. Bonds with a high degree of cash flow uncertainty, on the other hand, will also carry a good deal of variable price sensitivity, and this price sensitivity is clearly a liquidity consideration.
Thirty years ago, Dr. James V. Baker wrote about “Systems Theory Development” in his original work on asset/liability management. He championed the idea that a bank is a system of complex relationships that cannot be analyzed in complete isolation. The output of one decision serves as the input for another. This must be kept in mind while making investment decisions.
The events of the last year have taught many lessons. One of the most important is that sound liquidity-risk management is an absolute necessity for healthy, high-performing banks. The ability to define, measure and manage liquidity risk has never been more important, and the proper tools for identifying cash flows in future time periods is one of the key necessities. Banks wishing to shore up or enhance their liquidity risk management processes are wise to acquire and use the proper tools, and to maintain an investment management strategy that complements the liquidity profile of the institution.
Jeffrey F. Caughron is an associate partner at The Baker Group, Oklahoma City. Contact him at 888-990-0010.
Copyright © September 2009 BankNews Publications