ALCO Process - Liquidity Risk Management


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Liquidity Risk is normally a crucial issue in a banking crisis, however, during the 2007-2010 period, Liquidity has not been as difficult for us as we may have thought. There are many reasons for this, but number one is the fact that today’s community bankers simply have a better understanding of the various techniques for raising both retail deposits and wholesale funds. What does make this crisis a bit different is the relative pricing efficiencies in the wholesale or non-core funding arena these days and our session will focus on how bankers can avoid those difficult examiner discussions about the use of FHLB Advances and Brokered Deposits. It’s all about process and we will provide guidance on what needs to be in your ALCO Policy as it relates to wholesale funding. We will also explore the April 2010 Liquidity and Funds Management Guidance to ensure your bank is up to speed on those requirements. Finally, we will provide specific guidance on both Ratio Analysis and creating your Contingency Funding Plan and will review a sample CFP.

ALCO Process - Liquidity Risk Management

  1. 1. Liquidity Risk Management <ul><li>KPN Consulting Webinar Series </li></ul><ul><li>Part 2 </li></ul><ul><li>April 5, 2011 </li></ul>
  2. 2. <ul><li>The US economy remains almost comatose. The slump already ranks as the longest period of sustained weakness since the Depression. The economy is staggering under many “structural” burdens, as opposed to familiar “cyclical” problems. The structural faults represent once-in-a-lifetime dislocations that will take years to work out. Among them; the job drought; the debt hangover; the banking collapse; the real estate depression; the health care cost explosion and the runaway federal deficit. </li></ul>Time Magazine – September 1992
  3. 3. <ul><li>“ History does not repeat itself, but it often rhymes.” </li></ul>Mark Twain
  4. 4. Liquidity Risk <ul><li>The risk that an institution’s financial condition or overall safety and soundness is adversely affected by an inability (or perceived inability) to meet its obligations. </li></ul><ul><li>These include: </li></ul><ul><ul><li>Funding Mismatches; </li></ul></ul><ul><ul><li>Market constraints on the ability to convert assets into cash or in accessing sources of funds; and </li></ul></ul><ul><ul><li>Contingent liquidity events. </li></ul></ul>
  5. 5. Lessons From The Crisis <ul><li>Aggressive use of volatile funding sources </li></ul><ul><li>+ </li></ul><ul><li>Failure to establish adequate liquidity risk management practices </li></ul><ul><li>= </li></ul><ul><li>Considerable Financial Distress </li></ul>
  6. 6. Past Regulatory Oversight <ul><li>Much of the existing supervisory guidance on liquidity dates back to 1979 when the CAMELS ratings system was created. </li></ul><ul><li>In the past, examiners tended to focus more on balance sheet position than liquidity management. </li></ul><ul><li>Liquidity measures focused on assets as the liquidity source. </li></ul><ul><ul><li>Investments-liquid and Loans-illiquid </li></ul></ul><ul><li>Deposits were considered the only stable source of funding: </li></ul><ul><ul><li>Skepticism related to other sources of funding. </li></ul></ul>
  7. 7. Modern Perspective <ul><li>Traditional funding sources are still well regarded, but: </li></ul><ul><ul><li>Diversified funding is considered a positive; </li></ul></ul><ul><ul><li>High quality liquid assets are essential; </li></ul></ul><ul><ul><li>Both liquidity position and risk management are important; and </li></ul></ul><ul><ul><li>“ What if ?” planning is essential. </li></ul></ul>
  8. 8. Tools To Measure Liquidity Risk Static Balance Sheet Ratios Net Non-Core Funding Dependence Large Depositors to Total Deposits Loans to Deposits Pledged / Total Securities Loans to Assets Contingency Funding Plans Cash Flow Modeling Scenario Analysis Pro Forma Cash Flows
  9. 9. Are Static Ratios Outdated? <ul><li>“ Core” and “non-core” as defined in UBPR is limited </li></ul><ul><li>Many more short-term cash flows </li></ul><ul><li>Back-up funding not assessed </li></ul><ul><li>Quality of management not captured </li></ul>
  10. 10. Guidance issued by the basel committee on Banking Supervision (BCBS) 02/2000 Sound Practices for Managing Liquidity in Banking Organizations 1. Guidance was not translated into domestic policy. 2. Likely would have significantly mitigated the liquidity crisis seen during 2007 & 2008. 02/2008 Liquidity Risk: Management and Supervisory Challenges 09/2008 Principles for Sound Liquidity Risk Management and Supervision 1. Update to 2000 Guidance. 2. Principles served as a foundation for proposed U.S. Interagency Guidance. 12/2009 International Framework for Liquidity Risk Measurement, Standards, and Monitoring 1. Standards establish minimum levels of liquidity for internationally active banks. 2. Supervisors are free to adopt arrangements that set higher levels of minimum liquidity.
  11. 11. Interagency Policy Statement on Funding & Liquidity Risk Management <ul><li>Overview </li></ul><ul><li>The guidance outlines elements of sound liquidity risk management. Under the guidance, institutions should: </li></ul>Provide for effective corporate governance Establish appropriate strategies, policies, procedures, & limits Have in place comprehensive liquidity risk measurement & monitoring systems Actively manage intraday liquidity & collateral Maintain a diverse mix of existing & potential funding sources Maintain adequate levels of highly liquid assets Develop a comprehensive Contingency Funding Plan (CFP) Implement sufficient internal controls and internal audit processes
  12. 12. Corporate Governance <ul><li>Board of Directors </li></ul><ul><ul><li>Ensure that a liquidity risk tolerance is established and communicated in a manner that all levels of management clearly understand the institution’s approach to managing the trade-off between liquidity risk and short-term profits; </li></ul></ul><ul><ul><li>Oversee establishment and approval of liquidity management strategies, policies and procedures, and review them at least annually; </li></ul></ul><ul><ul><li>Understand the nature of the liquidity risk; </li></ul></ul><ul><ul><li>Establish executive-level lines of authority and responsibility for liquidity risk management; and </li></ul></ul><ul><ul><li>Understand and periodically review the CFP. </li></ul></ul>
  13. 13. Corporate Governance <ul><li>Senior Management </li></ul><ul><ul><li>Ensure that board-approved strategies, policies, and procedures are appropriately executed; </li></ul></ul><ul><ul><ul><li>Including: </li></ul></ul></ul><ul><ul><ul><ul><li>Overseeing development and implementation of appropriate risk measurement and reporting systems; </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Liquid buffers; </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Contingency Funding Plans; and </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Internal control infrastructure. </li></ul></ul></ul></ul><ul><ul><li>Report to the board regularly on the liquidity risk profile; </li></ul></ul><ul><ul><li>Determine the structure, responsibilities, and controls for managing liquidity risk; and </li></ul></ul><ul><ul><li>Monitor liquidity risk for each entity across the institution on an ongoing basis . </li></ul></ul>
  14. 14. Strategies, Policies, Procedures, & Risk Tolerances <ul><li>Strategies : </li></ul><ul><ul><li>Should be well documented, </li></ul></ul><ul><ul><li>Identify primary sources of funding daily operating cash outflows, as well as, cyclical cash flow fluctuations; and </li></ul></ul><ul><ul><li>Address alternative responses to various adverse business scenarios. </li></ul></ul><ul><li>Policies and procedures : </li></ul><ul><ul><li>Provide for formulation of plans and courses of actions for dealing with potential temporary, intermediate-term, and long-term liquidity disruptions. </li></ul></ul><ul><ul><li>Address liquidity separately for individual currencies, legal entities, and business lines; </li></ul></ul><ul><ul><li>Provide provisions for documenting and periodically reviewing assumptions used in the liquidity projections; </li></ul></ul><ul><ul><li>Specify the nature and frequency of management reporting; and </li></ul></ul><ul><ul><li>Clearly articulate an appropriate liquidity risk tolerances. </li></ul></ul>
  15. 15. Liquidity Risk Measurement, Monitoring, Reporting <ul><li>Measurement & Monitoring </li></ul><ul><ul><li>Include robust methods for comprehensively projecting cash flows arising from assets, liabilities, and off-balance sheet items over appropriate set of time horizons (i.e. pro forma cash flow statements). </li></ul></ul><ul><ul><ul><li>Reasonableness of assumptions is critically important </li></ul></ul></ul><ul><ul><li>Assess vulnerabilities to changing liquidity needs and ensure liquidity capacities are assessed within meaningful time horizons (i.e. intraday, day-to-day, monthly, up to one year, and one year or more). </li></ul></ul><ul><ul><ul><li>Assessments should include vulnerabilities to events, activities, and strategies that can significantly strain the capability to generate internal cash. </li></ul></ul></ul><ul><ul><li>Actively monitor and control liquidity risk at individual legal entity level, as well as, at a group-wide or consolidated level. </li></ul></ul>
  16. 16. Liquidity Risk Measurement, Monitoring, Reporting <ul><li>Measurement & Monitoring (continued) </li></ul><ul><ul><li>Stress Testing: </li></ul></ul><ul><ul><ul><li>Should be conducted regularly for a variety of institution-specific and marketwide events across multiple time horizons, and </li></ul></ul></ul><ul><ul><ul><li>Results should play a key role in developing the CFP </li></ul></ul></ul><ul><ul><li>Collateral Position Management: </li></ul></ul><ul><ul><ul><li>Should have the ability to calculate all collateral positions in a timely manner (i.e. value of assets currently pledged relative to the amount of security required and unencumbered assets available to be pledged); </li></ul></ul></ul><ul><ul><ul><li>Should be aware of the operational and timing requirements associated with accessing the collateral given its physical location; and </li></ul></ul></ul><ul><ul><ul><li>Should also fully understand the potential demand on required and available collateral arising from various types of contractual contingencies during periods of marketwide and institution-specific stress. </li></ul></ul></ul>
  17. 17. Liquidity Risk Measurement, Monitoring, Reporting <ul><li>Management Reporting </li></ul><ul><ul><li>Should provide aggregate information with sufficient supporting detail to enable management to assess the sensitivity of the institution to changes in market conditions, its own financial performance, and other important risk factors. </li></ul></ul><ul><ul><li>Liquidity Reports: </li></ul></ul><ul><ul><ul><li>Risk exposure, </li></ul></ul></ul><ul><ul><ul><li>Compliance with risk limits, </li></ul></ul></ul><ul><ul><ul><li>Consistency between management’s strategies and tactics, and </li></ul></ul></ul><ul><ul><ul><li>Consistency between these strategies and the board’s expressed risk tolerance. </li></ul></ul></ul>
  18. 18. Internal Controls <ul><li>Consist of procedures, approval processes, reconcilements, reviews, and other mechanisms designed to provide assurance that the institution management liquidity risk consist with board- approved policy. </li></ul><ul><li>Internal Controls should address: </li></ul><ul><ul><li>Adherence to policies and procedures; </li></ul></ul><ul><ul><li>Adequacy of risk identification; </li></ul></ul><ul><ul><li>Risk measurement; </li></ul></ul><ul><ul><li>Reporting; and </li></ul></ul><ul><ul><li>Compliance with applicable rules and regulations. </li></ul></ul><ul><li>Liquidity risk management process should be regularly reviewed and evaluated by an independent party. </li></ul>
  19. 19. Diversified Funding <ul><li>Funding strategy should provide effective diversification in sources of funding. </li></ul><ul><ul><li>Sources should be diversified in the short-, medium-, and long-term. </li></ul></ul><ul><ul><li>Sources should be diversified across a full range of retail, as well as, secured and unsecured wholesale sources. </li></ul></ul><ul><ul><li>Limits that address counterparties, secured versus unsecured, instrument type, and geographic market should be implemented. </li></ul></ul><ul><li>Funding concentrations should be avoided. </li></ul><ul><ul><li>Undue over-reliance on any one source of funding is considered an Unsafe and Unsound practice. </li></ul></ul>
  20. 20. Highly Liquid Assets <ul><li>A critical component to effectively responding to potential liquidity stress is the availability of a cushion of highly liquid assets without legal, regulatory, or operational impediments (unencumbered) that can be sold or pledged to obtain funds in a range of stress scenarios. </li></ul><ul><li>The size of the cushion should be supported by estimates of liquidity needs performed under stress testing, as well as, aligned with risk tolerance. </li></ul>
  21. 21. Contingency Funding Plan (CFP ) <ul><li>Contingent liquidity events arise from unexpected situations </li></ul><ul><li>ALL institutions should have a formal CFP that clearly identifies the strategies for addressing liquidity shortfalls in emergency situations. </li></ul><ul><li>The Plan should: </li></ul><ul><ul><li>Delineate policies to manage a range of stress environments; </li></ul></ul><ul><ul><li>Establish clear lines of responsibility; </li></ul></ul><ul><ul><li>Articulate clear implementation and escalation procedures; and </li></ul></ul><ul><ul><li>Be regularly tested and updated to ensure that it is operationally sound. </li></ul></ul>
  22. 22. Contingency Funding Plan (CFP ) Identify Stress Events Assess levels of severity and timing Assess funding sources and needs Identify potential funding sources Establish liquidity event management processes Establish a monitoring framework for contingent events
  23. 23. Contingency Funding Plan Sample
  24. 24. Contingency Funding Plan <ul><li>Stress Tests Appear to be Causing “Stress”… </li></ul><ul><li>Base & Short Term </li></ul><ul><li>12 Months Cash Flow and 7-10 Days Cash Flow </li></ul><ul><li>Going Out Of Business </li></ul><ul><li>Simulate the Event: Triggering Events, Deposits Loss, Funding Available, Reaction to Event </li></ul>3 Scenarios Base Case Short Term / External Crisis Case “ Going Out Of Business” Case
  25. 25. CFP <ul><li>“ Going Out Of Business” Scenario seems to be the Key! </li></ul><ul><li>Our Suggestion </li></ul><ul><li>Monthly Cash Flows for 12 Months using Quarter Ends as Key “Triggering” Events </li></ul>1 st Quarter End NPA Ratio increases from 1% to 5% Deposit Amount of 5% x Assets needs to be replaced HOW? 2 nd Quarter End Triggering Events – Another 5% HOW? 3 rd Quarter End Triggering Events – Another 10% HOW?
  26. 26. CFP <ul><li>A Key Issue is the solution set for new funding in this third scenario: </li></ul><ul><li>If specific Funding Sources have been Abused in the past, Choices will be Limited. </li></ul><ul><li>If use of Non-Core Funding has been Appropriate, finding new sources will be workable. </li></ul><ul><li>Strategy – use those sources that will disappear as the situation deteriorates. </li></ul>
  27. 27. CFP <ul><li>Key Question is which Funding Sources will be available as your situation deteriorates: </li></ul><ul><li>Loss of Well Capitalized Status is crucial given the importance of Brokered Deposits – this leads to use of Brokered in early stages knowing that Source will not be available in later stages. </li></ul>Final Stage Providers (Theoretically): 1. Federal Reserve 2. FHLB 3. Internet CDs (Qwickrate)
  28. 28. ALCO Process <ul><li>We believe that these kinds of “Cleansing Periods” lead to enhanced policies/procedures and a key area for improvement in the Community Bank world is the ALCO Process. </li></ul><ul><li>In particular, we see the Funds Management/Liquidity Section of the ALCO Policy requiring more definition. </li></ul><ul><li>Banks should fully describe how they intend to use Non-Core Funding – define overall limit, define each source and place limits on each. </li></ul><ul><li>Hopefully, this will lead to a robust discussion with Board/Examiners and provide real plan . </li></ul>
  29. 29. Liquidity <ul><li>Liquidity/Funds Management Concepts should appear in at </li></ul><ul><li>Least Three Documents: </li></ul>ALCO Policy (Limits & Sub-Limits on Funding Sources) Contingency Funding Plan (Consistency with ALCO Policy) Wholesale Funding Report
  30. 30. Wholesale Funding Report Sample
  31. 31. Regulator Concerns <ul><li>Regulators have expressed concern over several Issues … </li></ul><ul><li>Let’s look at these issues … </li></ul>
  32. 32. Brokered/High Rate Deposit Potential Supervisory Concerns <ul><li>Rapid growth which may result in less stringent underwriting or bringing on higher-risk assets </li></ul><ul><li>Liquidity issues may develop: </li></ul><ul><ul><li>337.6 restrictions </li></ul></ul><ul><ul><li>Deposit brokers restrictions </li></ul></ul><ul><ul><li>S & S enforcement actions </li></ul></ul><ul><li>Interest rate risk may increase due to higher price sensitivity </li></ul>
  33. 33. Banks Should Not Use Volatile Sources To Fund Aggressive Growth <ul><li>FDIC Financial Institution Letter 3-3-09 </li></ul><ul><li>1 and 2-rated banks will be monitored for growth </li></ul><ul><li>3,4, and 5-rated banks should have plans to stabilize or reduce risk exposure and limit growth </li></ul><ul><li>Plans should not include use of volatile funds or temporarily expanded FDIC insurance or liability guarantees to fund growth or risky activities </li></ul><ul><li>Continuing prudent lending practices not generally considered a risky practice </li></ul>
  34. 34. Overview Of Changes To 337.6 <ul><li>Recognizes that competition for deposit pricing has become more national in scope and ambiguity in determining normal market area has led in some cases to higher rates paid by problem banks, driving up rates for the industry. </li></ul><ul><li>Addresses problems using “national rate” as currently defined. “National rates” are compressed due to their direct linkage to US Treasury securities. </li></ul><ul><li>Establishes that the prevailing rate in all market areas would be the “national rate” as will be defined in the proposed regulation. </li></ul>
  35. 35. Overview Of Changes To 337.6 <ul><li>FDIC is calculating and publishing a schedule (weekly) of “national rates” and rate caps on Web site at: </li></ul><ul><li> </li></ul><ul><li>If a depository institution wishes to make the case that it is operating in a higher than average cost market, it would need to present the evidence to the FDIC which would review and make the determination on a case-by-case basis. </li></ul><ul><li>Changes Effective January 1, 2010 </li></ul>
  36. 36. Where Is This Headed? <ul><li>Crises Bring Improvement – mistakes are recognized and fixed. </li></ul><ul><li>Competitive Situation Changes – each crisis creates fewer players which typically leaves improved management. </li></ul><ul><li>Policies/Procedures Improve – Board must be more responsible and management must measure and monitor institutional risks. </li></ul><ul><li>Our Belief – Regulators may force improvements in Board knowledge/understanding. </li></ul>
  37. 37. Karl Nelson (770) 262-8446 [email_address]