Liquidity: Getting Started

define 'volatile' funding source

A volatile liability or deposit is a less stable source of funds that may disappear or be unavailable to the bank under heavy price competition, deteriorating credit or market risk conditions, and other possible adverse events.

increase in capital funds

Banks can improve their liquidity positions by raising capital through the public issuance of common stock, shareholder and stakeholder capital injections, and government programs, such as the Small Business Loan Fund (SBLF).

why is liquidity necessary for the bank to remain viable?

Liquidity is used to fund: 1. current operations 2. growth 3. maturing obligations

So, why is there so much concern among regulators over banks' overreliance on brokered deposits?

There are restrictions on brokered deposits for banks that fall below the PCA well-capitalized threshold. Specifically, bank that is not well-capitalized cannot accept or rollover brokered deposits without obtaining a waiver from the FDIC

T or F: A material use of wholesale funds can increase liquidity risk, particularly in certain circumstances, such as a credit crunch or when short-term borrowing rates are significantly high due to uncertain

true

- It is a safe and sound banking principle to fund.... - why?

* long-term assets with stable funding sources and * short-term assets with more volatile funding sources because stable liabilities exhibit longer-term maturity characteristics. Likewise, more volatile liabilities exhibit shorter-term maturity characteristics.

-what are the two main categories of earnings assets? -which is generally more liquid

- (1) loans and leases (2) securities - securities generally much more liquid of the two types.

- How do securities generally provide liquidity - However, lightly traded or exotic securities (such as structured notes) may become less liquid. How so?

- because they can be sold in the secondary market - either lose their marketability over time or an economic event may disturbt the functioning of the secondary market.

- define available-for-sale (AFS) securities - how are HTM securities accounted for on the balance sheet

- includes those not categorized as HTM or trading securities. In other words, the bank does not have the intent or ability to hold the security until maturity, but also does not intend to actively buy and sell it in the short-term for profitability. - AFS securities are reported at fair value with unrealized gains or losses from the changes in valuation reported as a separate component of capital

how do banks manage and control mismatch risk

- management must attempt to accurately project operational cash flow - to accomplish this, management estimates expected cash flow needs and ensures bank has adequate sources of liquidity to meet those estimates plus any additional small fluctuations.

- define Held-to-maturity (HTM) securities - how are HTM securities accounted for on the balance sheet

- purchased with the positive intent and ability to hold them until maturity. - at amortized cost (amount at which it was acquired). The valuation of HTM securities on the balance sheet remains unchanged until the securities mature.

- define asset marketability

- relative ease of disposing an asset without incurring a loss - true

list four account types that comprise nonmaturity deposits category:

1. DDA 2. savings account 3. NOW account 4. MMDA

Two more asset liquidity factors that apply specifically to the banks securities portfolio that management must consider:

1. How are the securities categorized for accounting purposes 2. Are securities pledged as collateral

what are the two basic approaches to managing liquidity?

1. asset management strategy 2. liability management strategy

Three key factors impacting bank managements decision on level of asset liquidity decisions.

1. balance sheet mix 2. marketability 3. maturity

Three (3) main characteristics of different types of deposits and funding

1. core deposits vs. noncore deposits 2. stable vs. volatile 3. retail vs. wholesale

Four notable factors, among others, which drive customers risk tolerance:

1. customer's relationship with their bank 2. interest rates paid on their deposits (above reflects two most primary drivers) 3. availability of insurance provided on the deposits 4. customer's reliance on public perception

three general types of liquidity risk

1. mismatch risk 2. contingent liquidity risk 3. market liquidity risk

two characteristics of long-term securities

1. more susceptible to greater fluctuations in valuations 2. generally less liquid

what are four categories of funding sources

1. net operating cash flows 2. generation of liabilities 3. liquidation of assets 4. increase in capital funds

A bank's mix of deposit accounts typically includes two broad categories - which are:

1. nonmaturity deposits 2. time deposits

Two reasons banks pledge securities

1. secure deposits from various public entities 2. provide collateral to borrow funds from the FHLB or other sources, including FRB discount window

three characteristics of short-term securities

1. trade closer to par value 2. exhibit lower valuation volatility 3. more liquid than long-term securities

Two key factor to consider when assessing liability liquidity:

1. whether or not the bank can obtain funds at a reasonable cost 2. whether the funds are a stable source.

Which of the three accounting categories for securities are least liquid

HTM securities - least liquid of three categories

____ generally are considered more stable sources of funding, unless the bank has a few large business or government entities as customers.

Nonmaturity deposits - generally are considered more stable sources of funding.

T or F: If the bank pays above market rates for funds, it raises a potential liquidity concern for an examiner.

True

T or F: maturity of an investment is another factor to consider when analyzing asset liquidity

True

T or F: Unpledged securities, especially those held as AFS, are considered to increase liquidity

True - Consequently, to maximize their liquidity position, most community banks will first pledge any securities held as HTM since the intent is to hold those securities till maturity anyway

T or F: The liquidity of an asset, such as a security or a loan, is only as strong as its market value relative to its book value.

True - Remember, liquidity is the ability to meet cash obligations at a reasonable cost. If a bank must sell assets at a steep discount to meet its obligations, it likely is experiencing serious liquidity problems.

T or F: The deposit mix also has earnings implications.

True - Time deposits typically cost more than non-maturity deposits.

T or F: Rates paid on brokered deposits may be higher than those paid for local-market-area retail deposits since brokered-deposit customers are generally focused on obtaining the highest FDIC-insured rate available

True - although banks can now more actively access brokered deposits due to technology. Brokered deposits, though categorized as noncore deposits, are often non-volatile. Particulary the case with brokered CDs, which are stable sources of fundings since a brokered CD can only be broken under extraordinary circumstances.

T or F: As a general rule of thumb, the more liquid the asset, the lower the return a bank would expect to receive.

True. Bank management is attempting to strike the right a balance of asset mix to achieve their ideal earnings/liquidity tradeoff.

liquidation of assets

bank use other sources of asset based liquidity when generate funds by liquidating or selling assets which are free of lines or pledges and by the planned runoff of a reserve of readily marketable assets at maturity

Define liquidity

bank's capacity to timely meet its cash and collateral obligations without incurring unacceptable losses.

net operating cash flows

banks obtain asset-based liquidity from operating cash flows by managing the time and maturity of their asset and liability cash flows.

why do banks with higher loan-to-asset ratios have a lower liquidity position

banks require a liquidity risk premium (plus a credit risk premium) for holding loans because of their relative illiquid status - think striking balance on right asset mix for earnings/liquidity tradeoff

why is maintaining a high level of liquid assets usually less critical at larger banks.

because larger banks typically have established wholesale funding sources

As mentioned, it is a safe and sound principle to fund long-term assets with stable funding sources and short-term assets with more volatile funding sources - why?

because stable liabilities exhibit longer-term maturity characteristics. Likewise, more volatile liabilities exhibit shorter-term maturity characteristics.

marketability must be considered for long-term securities held in the portfolio with the accounting designation of available-for-sale (AFS) - why?

because their valuation is more exposed to fluctuations from swings in market pricing.

why are AFS securities considered a secondary source of liquidity

because they either can be 1) sold to provide cash funding; or... 2) provide funding by being pledged.

list one account type which comprises time deposit category:

certificate of deposit (CD)

what is balance sheet mix

composition of asset types

- describe asset management strategy, typically used by community banks - what does this strategy focus on

convert securities or other liquid assets to cash to meet liquidity needs. - strategy focuses on maintaining sufficient amount of asset liquidity on the balance sheet because community banks typically have high level of customer core deposits

How does UBPR categorize deposits

core and noncore - this is a good starting point for examiners review of deposit mix. Although, note traditional categories may not accurately represent stability characteristics of deposits.

Historical characteristics of: - core deposits -noncore deposits

core deposits: 1) low-cost 2) relatively stable deposits noncore deposits: 1) higher-cost 2) more volatile deposits

Generally accepted accounting principles (GAAP) requires public companies to display their assets on the balance sheet in order of ___

decreasing liquidity.

Which type of deposits is usually considered the best source of low-cost deposits

demand deposits (DDA)

____ are typically the primary source of funds from the liability side of a bank's balance sheet, especially at smaller community banks

deposits

adequate liquidity depends on the banks ability to meet both____.

expected and unexpected cash flows and collateral needs without adversely affecting either daily operations or its financial condition.

The deposit mix funding characteristics of core versus noncore, stable versus volatile, and retail versus wholesale funding are all interchangeable terms.

false - These funding characteristics are not interchangeable. Each one brings a different perspective to assessing a bank's funding sources.

define brokered deposit

funds a bank obtains, directly or indirectly, through any deposit broker, for deposit into one or more accounts.

bank's liquidity risk increases when it pledges a --- percentage of its securities portfolio

high

What are common reasons prompting bank to categorize securities AFS

if bank holds securities to respond to (1) liquidity needs, (2) changes in market prices or interest rates, or (3) changes in tax position

determining factors of the level of non-interest bearing cash

levels of non-interest bearing cash usually kept as low as possible but high enough to fulfill operating needs.

Liquidity can also be obtained from the___ side of the balance sheet.

liability

Overall, what is generally the least liquid asset type on the balance sheet

loans

A rise in interest rates can cause investment securities to depreciate in value during the holding period. When this happens, ____

long-term securities will trade at a loss and limit their ability to be used as a source of liquidity

The liability management liquidity strategy typically is used by larger banks and includes ____

maintain funding agreements with various wholesale funding sources to manage the bank's liquidity. Funding is more evenly distributed between core deposits and noncore funding.

name the most liquid type of asset type on the balance sheet

noninterest bearing cash and due from banks

Generally speaking, define (1) retail funding and (2) wholesale funding (Note: 'retail' and 'wholesale' funding are catch-all terms for funding sources.)

retail funding - deposits from individuals/consumers. wholesale funding - funds obtained from the marketplace.

Market liquidity risk

risk that a bank will encounter market constraints (inadequate market depth or market disruptions) in its efforts to liquidate assets (without significantly lowering market prices) or to access financial market sources of funds.

Contingent liquidity risk

risk that arises when unexpected events cause a bank to have insufficient funds to meet its obligations.

mismatch risk

risk that bank will not have sufficient cash to meet obligations in the normal course of business, as a result of ineffective matches between cash inflows and outflows over a particular time period.

define liquidity risk

risk to a bank's financial condition arising from inability (whether real or perceived) to meet its contractual obligations.

A deposit's stability is related to the customer's ____

risk tolerance, or their willingness and ability to deposit money for a given risk and reward.

Bank interest-bearing assets perform the dual function of ____.

serving as a source of liquidity and providing income.

define 'stable' funding source

stable liability or deposit is a reliable source of funds that is likely to remain available in adverse circumstances.

generation of liabilities

through liability-based liquidity, bank can manipulate their liability structures through the discretionary acquisition of funds

T or F: As a general rule, The higher the percentage of the securities portfolio held as HTM, the less liquidity the portfolio provides. and.. the higher the percentage of the securities portfolio held as AFS, the more liquidity the portfolio provides.

true

T or F: Once pledged, the securities cannot be sold until the public entities' deposits are withdrawn, the borrowings are repaid or other collateral is substituted

true

T or F: The cost for, and availability of, the wholesale funds are important issues for banks using the liability management strategy. This approach results in more balance sheet debt and increases the risk that wholesale funds may either not be available when needed or not be available at a reasonable cost.

true

T or F: The key difference (in asset management strategy vs. liability management strategy) is that community banks tend to decide in which assets to invest based on their liability structure (usually a high level of customer deposits), while large banks create liability structures (attracting deposits and/or borrowing funds) to support the assets that they have chosen to hold

true

T or F: The level of on-balance sheet asset liquidity that a bank holds is an important management decision.

true

T or F: To maintain adequate liquidity, bankers must balance the costs and benefits—too little liquidity can create an exposure to various negative repercussions from its inability to meet contractual obligations, while too much liquidity can give rise to opportunity costs and negatively impact the bank's profitability.

true

T or F: To minimize liquidity mismatch risk, it generally is a sound practice for banks to match the maturity characteristics of both the uses (assets) and sources (liabilities) of its funds.

true

T or F: brokered deposit is a specific type of noncore deposit

true

T or F: different types of investment securities can be more liquid than others

true

T or F: noninterest bearing cash has no corresponding yields

true

T or F: converting assets into cash is an important part of funding cash flow mismatches and addressing contingent liquidity events.

true - Therefore, any market constraints on the successful conversion of assets to cash for planned, strategic or contingent liquidity needs could severely worsen funding mismatches and contingent liquidity problems

T or F: liquidity risk also arises from a bank's off-balance-sheet items.

true - When analyzing liquidity, you need to consider the amount and nature of off-balance-sheet items, and how they could potentially impact liquidity. Banks need to have access to enough liquidity to fund their off-balance sheet commitments.

For those institutions with a material reliance on brokered deposits, examiners should determine whether contingency funding plans address scenarios in which brokered funding is no longer available.

true - particularly important for banks whose capital ratios are close to well-capitalized minimums coupled with higher credit risk profiles.

t or f: Effective liquidity managers segment their liabilities into stable and volatile components on the basis of the liability's characteristics and their customers' risk tolerance factors.

true - when determining the banks liquidity position, be sure to assess the characteristics and behavior of its deposit accounts.