The Banking Crisis that occurred in March 2023 created a systematic shift in the way that liquidity is managed and monitored. This article examines liquidity before and after the March 2023 Banking Crisis.
Financial institutions are significantly impacted by external factors, some more so than others. These factors include but are not limited to the economy, regulatory, geo-political, technology and demographics. Rising interest rates and record levels of inflation have significantly impacted the financial position of financial institutions – compressed margins, significant unrealized losses on debt securities, and increasing credit quality concerns as borrowers use savings and additional borrowings to maintain elevated spending habits. Insufficient regulatory oversight and inadequate liquidity management, which contributed to the demise of some financial institutions earlier this year has caused an increase in the frequency and breadth of regulatory oversight since that time –which is not anticipated to subside anytime soon. The strained relations of the U.S. with other countries on various fronts (China and Russia to name a few) presents risks to financial institutions on a daily basis that require proper safeguards in place to ensure that they’re not exploited via cyber-crimes, or the impact of the economic strain noted previously. Continuously evolving technology is changing the way in which financial institutions operate (core) and conduct business (cloud/FedNow). Keeping pace with this change and being fiscally capable of funding these advancements in technology present additional risk. Last, the rapidly evolving workforce and customer base place stress on financial institutions by having to continually pivot based on employee and customer needs and wants.
Given this challenging environment in which financial institutions are currently operating in and the increasing number of risks which need to be mitigated; they cannot lose sight of first and foremost maintaining a sound liquidity position. However, given the events of the past year and the challenges discussed; the way in which Management manages liquidity and how the Board and regulators monitor liquidity has evolved to a more complex and robust model than before the 2023 Banking Crisis.
Management continues to contemplate what rates will do the balance of 2023 and in 2024; presenting challenges in selecting terms for funding options, investment portfolio composition (restructuring to recognize existing losses in the portfolio and acquire investments with higher yields?) and how and when to control loan growth volumes.
Before the 2023 Banking Crisis, liquidity analytics could be performed at a higher, static level and cash was king. However, in March of 2023, that all changed.
What should management be focusing on?
- Time sequenced liquidity
- On-balance sheet liquidity historically provided a false sense of cash availability – Management and Governance’s accurate understanding and monitoring the institution’s ability to convert to cash is significant and impactful to understanding the true liquidity position – liquidity availability should be monitored and reported convertible as follows:
- Immediate availability
- 1 Day
- 1 Week
- 1 Month
- Thereafter (forward-looking cash flows)
- These should be evaluated and stress-tested
- Fed master account availability (versus cash)
- When does cash become available in the Fed master account? This is now the driving factor in liquidity analysis versus cash on hand
- Cash and cash equivalent minimums should be no less than 2-5% of deposits and short-term borrowings however conservatively a 10% minimum threshold should be contemplated
- Ability to borrow (capacity) versus balance sheet liquidity
- On the balance sheet, liquidity minimums should be established at greater than 10% of deposits and short-term borrowings
- Borrowing capacity minimums should be established at greater than 10% of deposits and short-term borrowings
- The Bank Term Funding Program (BTFP) provides financial institutions with same day borrowing availability, qualifying investment securities are pledged at PAR value, and the structure of the borrowing is favorable compared to similar funding alternatives
- Investment securities should be pledged to secure the BTFP even if it reduces on-balance sheet liquidity to less than 10% as this funding source is immediately available versus the time and effort to convert to cash
- Other same day availability funding typically also includes FHLB and FRB
- Pledged assets should be reviewed at least quarterly
- Other borrowing sources should be in place as well (these typically include unsecured borrowings and other lines – however, in times of financial strain on the industry these sources could dry up)
- The Bank Term Funding Program (BTFP) provides financial institutions with same day borrowing availability, qualifying investment securities are pledged at PAR value, and the structure of the borrowing is favorable compared to similar funding alternatives
- The ability to use brokered (or listing) deposits as a funding source (the regulatory tabu associated with these has subsided)
- Large deposits (defined as those that are over FDIC insured limits, large as defined by the institution and uninsured deposits)
- On-balance sheet liquidity historically provided a false sense of cash availability – Management and Governance’s accurate understanding and monitoring the institution’s ability to convert to cash is significant and impactful to understanding the true liquidity position – liquidity availability should be monitored and reported convertible as follows:
Management’s analysis now should be conducted in a dynamic versus a static manner.
Assessment of individual risks at a financial institution need to be more granular in nature and incorporate more volatility. Additional scrutiny and monitoring should be occurring over the following areas:
- Deposit concentration
- No longer focusing on core and wholesale
- Now focusing on stable and volatile
- Understanding and documenting customer loyalty
- Short Term Volatile funds include wholesale funding and listing service deposits with maturities or less than three months and core and non-core deposits with a lower loyalty score
- Long Term Volatile funds include wholesale funding and listing services deposits with maturities between three months and one year and core and non-core deposits with a moderate loyalty score
- Stable funds include wholesale funding and listing service deposits with maturities greater than one year and core and non-core deposits with a higher loyalty score
- Uninsured deposits
- Review composition
- Assign an NAICS code to each
- Compare to 1 Day Liquidity Levels
- Note that this uninsured deposit risk can be mitigated via the IntraFi network
- Industry concentrations
- Impact of growth on the financial institution
- Impact of unrealized gains and losses on the financial institution
- Consider excluding underwater investment securities from balance sheet liquidity
- Understanding the impact of selling held-to-maturity (HTM) investment securities
- Tainting the portfolio
- Negative economic indicator to the marketplace
- Ongoing monitoring and self-assessment of CAMELS (Capital, Asset Quality, Earnings, Liquidity, Sensitivity) ratings
- Economic value of equity (EVE) should now also be run using scenarios reflecting the use of contingency fundings as well as liquidation (run on the bank)
What should you be doing now?
- If your processes have not already been enhanced to be reflective of the items discussed above, they should be revisited and revised
- Update policies and procedures, as required
- Updating reporting and monitoring accordingly
- Increased, continuous training for staff that are involved in modeling and decision making processes
- Revisiting the frequency of and the robustness of analysis performed
- Analysis should be conducted at a more granular level than historically
- For example, additional analysis of Accumulated Other Comprehensive Income (Loss) should be performed whereby the changes in levels of losses should be contemplated as it relates to levels of capital
- If not already established, trigger points should be determined that would move investment securities from Available-for-sale (AFS) to HTM
- For example, additional analysis of Accumulated Other Comprehensive Income (Loss) should be performed whereby the changes in levels of losses should be contemplated as it relates to levels of capital
- Various scenarios should be run that contemplate increasing levels of stress on the institution
- Deposit outflows should be tracked with regular period reporting segregated by ultimate destination
- Analysis should be conducted at a more granular level than historically
- Continue to re-evaluate your anticipated future cash flows
- Continue to challenge underlying assumptions used
- Continue to evaluate customer behaviors in this challenging economic environment
If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.