ALCO Process - Liquidity Risk Management

Liquidity Risk Management

KPN Consulting Webinar SeriesPart 2

April 5, 2011

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.Time Magazine – September 1992

“History does not repeat itself, but it often rhymes.”

Mark Twain

Liquidity Risk

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.

These include:Funding Mismatches;Market constraints on the ability to convert assets into

cash or in accessing sources of funds; and Contingent liquidity events.

Lessons From The Crisis

Aggressive use of volatile funding sources

+Failure to establish adequate liquidity risk

management practices

=

Considerable Financial Distress

Past Regulatory Oversight

Much of the existing supervisory guidance on liquidity dates back to 1979 when the CAMELS ratings system was created.

In the past, examiners tended to focus more on balance sheet position than liquidity management.

Liquidity measures focused on assets as the liquidity source.Investments-liquid and Loans-illiquid

Deposits were considered the only stable source of funding:Skepticism related to other sources of funding.

Modern Perspective

Traditional funding sources are still well regarded, but:

Diversified funding is considered a positive;High quality liquid assets are essential;Both liquidity position and risk management are

important; and “What if ?” planning is essential.

Tools To Measure Liquidity Risk

Static Balance Sheet RatiosNet Non-Core Funding Dependence

Large Depositors to Total Deposits

Loans to Deposits

Pledged / Total Securities

Loans to Assets

Contingency Funding PlansCash Flow Modeling

Scenario Analysis

Pro Forma Cash Flows

Are Static Ratios Outdated?

“Core” and “non-core” as defined in UBPR is limited

Many more short-term cash flows

Back-up funding not assessed

Quality of management not captured

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.

Interagency Policy Statement on Funding & Liquidity Risk Management

OverviewThe guidance outlines elements of sound liquidity risk management. Under the guidance, institutions should:

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

Corporate GovernanceBoard of Directors

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;

Oversee establishment and approval of liquidity management strategies, policies and procedures, and review them at least annually;

Understand the nature of the liquidity risk; Establish executive-level lines of authority and

responsibility for liquidity risk management; andUnderstand and periodically review the CFP.

Corporate GovernanceSenior Management

Ensure that board-approved strategies, policies, and procedures are appropriately executed;Including:

Overseeing development and implementation of appropriate risk measurement and reporting systems;

Liquid buffers;Contingency Funding Plans; and Internal control infrastructure.

Report to the board regularly on the liquidity risk profile;Determine the structure, responsibilities, and controls for managing

liquidity risk; andMonitor liquidity risk for each entity across the institution on an

ongoing basis.

Strategies, Policies, Procedures, & Risk TolerancesStrategies:

Should be well documented, Identify primary sources of funding daily operating cash

outflows, as well as, cyclical cash flow fluctuations; andAddress alternative responses to various adverse business

scenarios.

Policies and procedures:Provide for formulation of plans and courses of actions for

dealing with potential temporary, intermediate-term, and long-term liquidity disruptions.

Address liquidity separately for individual currencies, legal entities, and business lines;

Provide provisions for documenting and periodically reviewing assumptions used in the liquidity projections;

Specify the nature and frequency of management reporting; andClearly articulate an appropriate liquidity risk tolerances.

Liquidity Risk Measurement, Monitoring, Reporting

Measurement & Monitoring

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).Reasonableness of assumptions is critically important

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).Assessments should include vulnerabilities to events, activities, and

strategies that can significantly strain the capability to generate internal cash.

Actively monitor and control liquidity risk at individual legal entity level, as well as, at a group-wide or consolidated level.


Measurement & Monitoring (continued)

Stress Testing:Should be conducted regularly for a variety of institution-specific and

marketwide events across multiple time horizons, andResults should play a key role in developing the CFP

Collateral Position Management: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);

Should be aware of the operational and timing requirements associated with accessing the collateral given its physical location; and

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.


Management Reporting

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.

Liquidity Reports:Risk exposure,Compliance with risk limits,Consistency between management’s strategies and tactics,

and Consistency between these strategies and the board’s

expressed risk tolerance.

Internal ControlsConsist of procedures, approval processes,

reconcilements, reviews, and other mechanisms designed to provide assurance that the institution management liquidity risk consist with board- approved policy.

Internal Controls should address:Adherence to policies and procedures;Adequacy of risk identification;Risk measurement;Reporting; and Compliance with applicable rules and regulations.

Liquidity risk management process should be regularly reviewed and evaluated by an independent party.

Diversified Funding

Funding strategy should provide effective diversification in sources of funding. Sources should be diversified in the short-, medium-, and

long-term.Sources should be diversified across a full range of retail,

as well as, secured and unsecured wholesale sources.Limits that address counterparties, secured versus

unsecured, instrument type, and geographic market should be implemented.

Funding concentrations should be avoided.Undue over-reliance on any one source of funding is

considered an Unsafe and Unsound practice.

Highly Liquid Assets

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.

The size of the cushion should be supported by estimates of liquidity needs performed under stress testing, as well as, aligned with risk tolerance.

Contingency Funding Plan (CFP)Contingent liquidity events arise from unexpected

situations

ALL institutions should have a formal CFP that clearly identifies the strategies for addressing liquidity shortfalls in emergency situations.

The Plan should:Delineate policies to manage a range of stress environments;Establish clear lines of responsibility; Articulate clear implementation and escalation procedures; andBe regularly tested and updated to ensure that it is operationally

sound.

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

Contingency Funding Plan

Sample

Contingency Funding PlanStress Tests Appear to be Causing “Stress”…

Base & Short Term12 Months Cash Flow and 7-10 Days Cash Flow

Going Out Of BusinessSimulate the Event: Triggering Events, Deposits Loss, Funding

Available, Reaction to Event

3 ScenariosBase Case

Short Term / External Crisis Case

“Going Out Of Business” Case

CFP“Going Out Of Business” Scenario seems to be the Key!

Our SuggestionMonthly Cash Flows for 12 Months using Quarter Ends as Key “Triggering” Events

1st Quarter End

NPA Ratio increases from 1% to 5%Deposit Amount of 5% x Assets needs to

be replacedHOW?

2nd Quarter End

Triggering Events – Another 5%HOW?

3rd Quarter End

Triggering Events – Another 10%HOW?

CFP

A Key Issue is the solution set for new funding in this third scenario:

If specific Funding Sources have been Abused in the past, Choices will be Limited.

If use of Non-Core Funding has been Appropriate, finding new sources will be workable.

Strategy – use those sources that will disappear as the situation deteriorates.

CFPKey Question is which Funding Sources will be

available as your situation deteriorates:

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.

Final Stage Providers (Theoretically):

1. Federal Reserve

2. FHLB

3. Internet CDs (Qwickrate)

ALCO Process

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.

In particular, we see the Funds Management/Liquidity Section of the ALCO Policy requiring more definition.

Banks should fully describe how they intend to use Non-Core Funding – define overall limit, define each source and place limits on each.

Hopefully, this will lead to a robust discussion with Board/Examiners and provide real plan.

Liquidity

Liquidity/Funds Management Concepts should appear in at

Least Three Documents:

ALCO Policy (Limits & Sub-Limits on Funding

Sources)

Contingency Funding Plan (Consistency with ALCO Policy)

Wholesale Funding Report

Wholesale Funding Report

Sample

Regulator Concerns

Regulators have expressed concern over several Issues …

Let’s look at these issues …

Brokered/High Rate Deposit Potential Supervisory Concerns

Rapid growth which may result in less stringent underwriting or bringing on higher-risk assets

Liquidity issues may develop: 337.6 restrictions Deposit brokers restrictions S & S enforcement actions

Interest rate risk may increase due to higher price sensitivity

Banks Should Not Use Volatile Sources To Fund Aggressive Growth

FDIC Financial Institution Letter 3-3-09 1 and 2-rated banks will be monitored for growth3,4, and 5-rated banks should have plans to stabilize or

reduce risk exposure and limit growthPlans should not include use of volatile funds or

temporarily expanded FDIC insurance or liability guarantees to fund growth or risky activities

Continuing prudent lending practices not generally considered a risky practice

Overview Of Changes To 337.6

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.

Addresses problems using “national rate” as currently defined. “National rates” are compressed due to their direct linkage to US Treasury securities.

Establishes that the prevailing rate in all market areas would be the “national rate” as will be defined in the proposed regulation.

Overview Of Changes To 337.6

FDIC is calculating and publishing a schedule (weekly) of “national rates” and rate caps on Web site at:

http://www.fdic.gov/regulations/resources/rates/index.html

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.

Changes Effective January 1, 2010

Where Is This Headed?

Crises Bring Improvement – mistakes are recognized and fixed.

Competitive Situation Changes – each crisis creates fewer players which typically leaves improved management.

Policies/Procedures Improve – Board must be more responsible and management must measure and monitor institutional risks.

Our Belief – Regulators may force improvements in Board knowledge/understanding.

Karl Nelson(770) 262-8446

[email protected]