Summer 2017 Supervisory Insights Overview: Community Bank Liquidity Risk
On August 30, 2017, the Federal Deposit Insurance Corporation (FDIC) released its summer 2017 Supervisory Insights journal, which includes an article discussing liquidity risk management and contingency funding strategies to help community banks mitigate potential stress scenarios. This article is timely, as the FDIC has recently observed isolated instances of liquidity stress at a small number of insured banks.
Liquidity Risk Trends
According to Call Report data, the ratio of loans to total assets has risen sharply since 2012 for banks with less than $10 billion in assets, although liquid asset holdings compared to total assets have decreased. The FDIC said this may be due to community banks’ increasing reliance on non-core and wholesale funding sources, along with increasing use of municipal bonds.
Non-Core & Wholesale Funding Sources
Non-core funding sources could include, but aren’t limited to:
- Federal Home Loan Bank (FHLB) advances
- Short-term correspondent loans
- Other credit facilities
- Brokered certificates of deposit (CDs)
- CDs larger than $250,000
Wholesale funding sources could include, but aren’t limited to:
- Brokered deposits
- Internet deposits
- Deposits obtained through listing services
- Foreign deposits
- Public funds
- Federal funds purchased
- FHLB advances
- Correspondent credit lines
Non-core and wholesale sources can be a component of a well-managed liquidity and funding strategy; however, the FDIC has noticed some institutions have used these funding sources to fuel aggressive loan growth or other leverage strategies. The FDIC recommends viewing non-core funding as complementary to core deposits rather than as a substitute. Core deposits can have advantages over non-core and wholesale funding sources as they are more stable, cost less and tend to re-price more favorably when conditions change. In addition, the FDIC warns high-rate and uninsured deposit accounts may be volatile in certain cases and can have characteristics similar to non-core or wholesale funding.
Benefits of Liquid Assets
According to the FDIC, a cushion of unencumbered liquid assets is the first line of defense for responding to a liquidity event; however, liquid assets have been decreasing since 2012. According to the FDIC, the most marketable and liquid assets typically consist of:
- U.S. Department of the Treasury and agency securities
- Short-term, investment-quality money market funds
- Federal Reserve or correspondent deposits
Prices of fixed-income instruments typically decline when interest rates rise. Therefore, with increasing interest rates, institutions could incur unrealized losses in the liquid asset pool. Realized losses would then be incurred if the securities are sold, which may constrain balance sheet resources and may lead to lower collateral amounts available to secure future borrowings.
Increasing community bank investments in municipal bonds may be another reason liquid assets are decreasing. As of December 31, 2016, almost a quarter of all insured financial institutions had municipal bond holdings exceeding the level of Tier 1 capital. Prior to the recession, as of December 31, 2007, only 10 percent of insured financial institutions had this level of municipal bond holdings. A drawback of municipal bonds is that they’re generally less liquid and marketable than U.S. government and agency-guaranteed securities for several reasons, including their long durations.
Brokered Deposit & Interest Rate Restrictions
The FDIC doesn’t restrict an institution from obtaining brokered deposits if the institution is profitable and well capitalized under Prompt Corrective Action capital regulations. However, the FDIC warns an adequately capitalized insured depository institution without an FDIC waiver will be prohibited from accepting, renewing or rolling over any brokered deposits. Similarly, an undercapitalized insured depository institution also is prohibited from accepting, renewing or rolling over brokered deposits due to restrictions under Section 29 of the Federal Deposit Insurance Act of 1950 (FDI Act).
In addition, the FDI Act limits the interest rate an institution may pay to no more than 75 basis points above the average national rates (or prevailing local market rates if operating in a high-rate area), which the FDIC can’t waive. This rate cap also applies to interest rate-sensitive deposits such as internet deposits or deposits attracted because of higher interest rates. The effects of this regulation may be made worse because these restrictions are often triggered at the same time other funding counterparties decrease credit availability or demand higher collateral ratios. This makes it difficult to replace deposit runoff with other funding.
Uninsured Public Deposits
Many states require public funds to be protected by deposit insurance, a pledge of government securities or standby letters of credit (SBLC) issued by the FHLB. A potential downside of using an SBLC is that the FHLB requires the pledging of assets that are unavailable for conversion to cash or for use as collateral. Furthermore, any deterioration in the underlying assets may result in the FHLB requiring more collateral to secure the SBLC, likely during a time when the institution has the greatest need for liquidity.
Contingency Funding Plan (CFP)
A CFP is an institution’s strategy to address unexpected liquidity shortfalls caused by internal or external circumstances. Risk tolerances and recovery strategies need to be sufficiently reflected in the asset liability management program and CFP. FDIC examiners have recently identified CFP deficiencies at banks that rely on less-stable funding sources. These deficiencies have been addressed by improving scenario testing by factoring in brokered deposit and interest rate restrictions, understanding asset encumbrances and aligning the CFP with the bank’s risk profile and activity.
The 2010 Interagency Policy Statement on Funding and Liquidity Risk Management and the FDIC Risk Management Manual of Examination Policies suggest a well-developed CFP should outline policies and risk-mitigation actions for a range of stress scenarios by establishing responsibilities, including details of implementation, escalation and communication procedures. The CFP also should identify early warning indicators and remediation steps detailing how contingent funding sources would be used.
Unanticipated events such as rising credit defaults, operational losses, damage to a bank’s reputation, disruptions in deposit gathering or unwillingness of counterparties to roll over debt can cause severe liquidity shortfalls. In addition, uninsured depositors could make significant withdrawals if a bank encounters financial stress or negative public attention.
To determine the liquidity buffer’s size, the FDIC recommends first assessing normal cash flow needs, then projecting expected or unexpected needs as measured by liquidity cash flow forecasts. The liquid asset buffer can provide liquidity in a stressed environment, complemented by secondary and tertiary funding sources.
Liquidity Cash Flow Forecasting
Poor contingency funding planning and cash flow forecasting contributes to liquidity strain. The FDIC recommends analyzing cash flow forecasts using different stress scenarios. The FDIC considers pro forma cash flow analyses to be a valuable risk management process, especially for institutions that rely on non-core funding sources or other sources sensitive to market forces. Safety-and-soundness principles for these analyses are outlined in the Interagency Policy Statement mentioned above.
The article lists several post-analysis questions management should consider, including:
- Are cash flow surplus limits consistent with the board’s risk tolerance?
- Can mitigating actions by management bring liquidity back within desired limits?
- Are secondary and tertiary borrowing lines sufficient for cash flow needs during a stressed environment?
- How liquid are various securities in the investment portfolio?
For additional information regarding supervisory observations, municipal bond credit analysis, liquidity risk management, contingency funding strategies and liquidity cash flow forecasting, read the summer 2017 Supervisory Insights journal in its entirety.
Contact your trusted BKD advisor if you have questions.