Assessing the Impact of COVID 19 on Liquidity Needs

Dave Koch
April 14, 2020
Read Time: min

Managing through uncertainty

It is no secret that we are all trying to cope with and manage through the uncertainty due to the coronavirus and the health and economic impacts of COVID 19. The impact to financial institutions is of utmost concern to us at Abrigo, and we are committed to helping our 2500+ clients as they face uncertainty in earnings and cash flow.

The ability of financial institutions to make concessions and work to provide the markets with assurances is a direct result of their overall financial well-being, as well as their nimbleness. After the Great Recession, financial institutions retained more capital to build in buffers to face uncertain times like this. Now is the time they need them, and these buffers are being put to work. Credit underwriting has become more rigorous, helping financial institutions to better understand potential risks, which should help them find ways to work with borrowers that are facing risks in today’s environment. Technology investments of recent years are helping to seamlessly allow both workers and customers maintain relationships and business activities, even if they are a bit more challenged than when using traditional methods. In all, financial institutions are generally well prepared in the areas that they could control to deal with this “crisis”.

Now that all of the financial institutions’ planning is being called into action, it’s important to realize that the best laid plans sometimes go awry. All plans are based on two variables: things we can control, and things that we cannot control. One of the major concerns today is the unknowns that impact plans that we do not control. Let’s focus on the financial risks we don’t control and assess the risk.

During the crisis in 2009, the banking system saw shockwaves hit, causing a number of bank closures. Most of these were due to a lack of underlying liquidity. This liquidity drain was, in most cases, a direct result of increased credit risk and funding sources used to grow the banks. In short, liquidity was the final straw for many banks that failed, but in most cases, credit risk was the disease that made them sick.

Today’s situation is 180 degrees from that environment. Financial institutions today are holding higher levels of capital, and their overall credit underwriting processes were upgraded to avoid mistakes of the past. What we have now is not a series of less secure banks being hit with losses, but rather strong banks and borrowers having to adapt to a sudden change in overall economic activity. Borrowers are facing uncertainty around cash flows as factory orders slow, rents from tenants extend, and other issues that are related to their future income levels are hampered by the need to stop a nasty disease from spreading. Workers that are uncertain of their future paychecks are likely to hoard cash, use existing lines of credit to preserve funds to meet basic living needs, and hope to stay out of harm’s way. It has been repeated by so many that this is not a financial crisis like the Great Recession. While the cause is a non-financial agent, we all understand that this is in fact a financial crisis, but beyond the financial sector.

To help bankers think through the ways they might be proactive in their financial institutions to weather yet another storm, here are several things that need attention and continued monitoring. The financial institution’s internal plan should include at least the following.

Document plans for credit concerns

First, the internal plan needs a documented plan for credit concerns, including borrower forbearance, loan initiatives, etc. Make sure all staff and members of the board of directors understand how you are handling the expected slowdown in loan repayments, and what steps are being taken with individual borrowers to support them, and for how long. The message sent from all team members needs to be unified.

Second, the internal plan should take into account the fact that the slowdown in loan repayments will put a kink in the flow of funds coming back to the institution. This flow of repayments is the major source of “liquidity” in the community banking system. While financial institutions have cash and securities they can use to help meet needs and pay bills, that amount is not usually enough to sustain an institution for very long. For some time now, institutions have had a “contingency funding plan” that outlines the various sources of other funding alternatives like Federal Home Loan Bank advances, Federal Reserve discount window borrowings, brokered CDs, etc. Now is the time to get those plans out and review the stress scenarios you defined to see if there is any good match to current concerns.

Accurately assess current liquidity levels

Third, the financial institution needs to get an accurate assessment of current liquidity levels. This measure needs to consider all asset sources (at appropriate discounted values) available to fund all potential uses. Uses include assumed deposit outflows that account for not only withdrawals, but also the slowdown in overall payroll\business deposit inflows due to the general market slowdown. If the institution has maturing wholesale sources, the usual regulatory response is to plan to pay them off. But now, perhaps that plan has changed to renewing them for a period to ensure access to cash. It is also a good idea to incorporate an assumption on how many outstanding lines of credit (consumer or business) might tap that line, requiring the financial institution to fund that request. During the last crisis, many institutions started to trim the level of credit borrowers might have available. That option exists again. However, be careful on rationale and documentation for the change. This must be done in a consistent and well-documented fashion. This would not be a good time for bad PR.

Assessing the sources of liquidity and the potential uses of liquidity should cover a timeframe of no less than 30-60 days and possibly out 90-120 days. The analysis should be revisited regularly through this event to see how actual behavior matches our scenarios. About scenarios, we would recommend an expected, adverse, and worst case set of plans that graduate the required need for funding.

Once the financial institution has these plans, it can return to the contingency funding plan and evaluate external sources for funds to determine what source offers the coverage needed for the terms that have been modeled, and the associated cost of these options. Be sure to keep a close eye on any internal concentration or liquidity policy limits that restrict usage to a specified level and report how the execution of the plan will manage compliance and ultimately the repayment of these funds. Ideally the plan will lay out the amounts of funds planned to use from each of the sources depending on the impact from the three scenarios. Keep in mind that both market conditions and the institution’s financial condition can change the availability of some of these sources, while others like internet or rate board CDs are “market driven” and given the market right now, may be a slower response to access the funds needed.

Monitor key metrics daily for deterioration

Daily identify what metrics are being monitored to determine if the alert levels are changing from the expected to adverse or worse levels. It is our recommendation that financial institutions watch a daily report of new draws on credit lines, large deposit outflows, and a more granular report on past-due loan payments.

As we work our way through this cycle, more lessons are to be learned. Learning happens in many ways. Some theorize there are 4 ways people learn. Some learn by seeing what to do and then doing it. Others like to hear what to do, then apply what they heard. Others like to read about the subject. Lastly, there are those who learn best by doing. If we were simply trying to do something like learn a new language, then these learning styles would be more applicable. Rather we are faced with having to mix all 4 styles and then get to the stage of “doing” faster than some are comfortable with. As you are going through this process, consider how your learning style impacts your decision-making. Look to find assistance within your team or your partnerships within the industry to help fill the gaps and get to an answer faster so that your financial institution appropriately considers the potential risks in the credit portfolio, assesses depositor risks, and builds strong and affordable funding plans.

For now, be safe and show everyone why community financial institutions are the backbone of the economy. This too shall pass.

 

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About the Author

Dave Koch

Since 1989, Dave has delivered educational programs on Asset/Liability Management and pricing topics to Federal Regulatory Agencies, national and state industry trade groups, Federal Home Loan Banks, and Corporate Credit Unions nationwide. Dave currently serves on the faculty of the Graduate School of Banking at the University of Wisconsin – Madison as well as numerous other industry schools. In addition to his speaking roles, Dave is actively involved with Abrigo clients consulting with them on capital planning, loan & deposit pricing, and other ALM concerns in an effort to make the ALCO processes more effective. Abrigo and Dave are committed to helping the community financial industry develop workable strategies and risk management processes to improve financial performance, regulatory compliance and overall solutions to their business challenges.

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