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ALM 101: Introduction to Asset/Liability Management-Part 4: Liquidity Risk

Zach Langley
April 15, 2022
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ALM & Measuring Liquidity Risk at Banks and Credit Unions

Regulatory agencies expect financial institutions to manage liquidity risk using processes and systems commensurate with the complexity, risk profile, and scope of operations. This is the fourth post in a series.  

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Defining Liquidity
Liquidity: capacity to meet obligations at a reasonable cost

So far in this “Introduction to ALM” blog series, we’ve looked at the two different measures of interest rate risk: earnings at risk (EAR) or income at risk (IAR) and economic value of equity (EVE) or value at risk (VAR). To continue the series, we’ll look at a different type of risk addressed in asset/liability management: liquidity risk.

Liquidity is defined as the capacity to meet cash and collateral obligations readily at a reasonable cost.
“At a reasonable cost” is the key to this definition. Institutions want to maintain reliable sources of liquidity without being overly reliant on contingent sources of liquidity that prove to be costly.

ALM 101 blog series

 

ALM 101: Introduction to Asset/Liability Management

 

Regulators expect that for institutions to maintain adequate levels of liquidity, banks and credit unions must be able to meet both expected and unexpected cash flow and collateral needs without adversely affecting daily operations or financial performance. As is the case with effectively managing interest rate risk, managers need to understand their cash flows in and out of the institution to effectively manage liquidity and meet all regulatory requirements.

In addition to understanding cash flow dynamics, managers should ensure they focus on being able to address the following considerations regarding liquidity:

  • How much liquidity do we have?
  • How fast can we get the money?
  • How do our sources of liquidity fluctuate with changing market conditions or possible changes in our financial condition?
  • What events could jeopardize our operational liquidity?
  • How will we monitor our liquidity needs, and can we anticipate problems before they materialize?
  • What is our response if we see problems coming?
  • Do we have a sufficient buffer in addition to the minimal regulatory requirements on liquidity?

Proper liquidity risk management includes keeping a finger on the pulse of liquidity levels and having defined plans to address any anticipated liquidity shortages sooner rather than later.

 

Regulatory expectations for liquidity

Regarding liquidity, regulatory expectations include requirements that institutions forecast their liquidity management and stress test key assumptions used in the forecast. Assumptions play a critical role in the construction of liquidity measures and the development of cash flow projections. Liquidity risk managers need to ensure that all assumptions are reasonable and appropriate. Key assumptions should be reviewed, documented, and approved annually.

Along with this, strong liquidity reporting and monitoring processes are expected, including strict guidelines on liquidity positions such as operating levels and use of contingent sources.

Financial Institutions
Sources of liquidity and liquidity risk

Liquidity can come from different sources. The most common source is cash and high-quality assets that can be converted to cash, otherwise known as high-quality liquid assets (HQLA). Liquidity can also come from “trickle” sources (sources that trickle in) like loan repayments, investment repayments, and maturities not in the HQLA pool, as well as any planned deposit growth. The last source of liquidity is what we call contingent sources, which are typically borrowing lines.

Financial institutions, regulators, and others consider a few different metrics to measure how much liquidity the bank or credit union has. These metrics include:

Asset-based liquidity. Asset-based liquidity measures whether liquidity from core sources (such as cash or HQLA) can cover daily operational needs such as deposit withdrawals and loan originations. This is the standard metric used to evaluate an institution’s liquidity levels; however, it does not take into account all sources of liquidity available to the institution.

Total or cash flow-based liquidity. Total liquidity or cash flow-based liquidity takes into account all sources of liquidity with the goal of ensuring that projected cash flows maintain sufficient sources to meet financial obligations such as withdrawals, originations, and other commitments. When using a cash flow-based metric, it’s important to understand to what extent liquidity is changing — the level as well as what sources of liquidity are changing. If the supply of cash and other readily available liquidity sources is dwindling, this needs to be identified and addressed before the institution runs into potential issues in the future. This type of measure should also take into account debt and borrowing capacities.

Contingent liquidity. Contingent liquidity incorporates emergency sources of liquidity, such as asset sales, wholesale borrowing, and other non-core funding sources.

Financial institutions, regulators, and others consider a few different metrics to measure how much liquidity the bank or credit union has. 

Here are three:

Asset-based liquidity.

Asset-based liquidity measures whether liquidity from core sources (such as cash or HQLA) can cover daily operational needs such as deposit withdrawals and loan originations. This is the standard metric used to evaluate an institution’s liquidity levels; however, it does not take into account all sources of liquidity available to the institution.

Total or cash flow-based liquidity.

Total liquidity or cash flow-based liquidity takes into account all sources of liquidity with the goal of ensuring that projected cash flows maintain sufficient sources to meet financial obligations such as withdrawals, originations, and other commitments. When using a cash flow-based metric, it’s important to understand to what extent liquidity is changing — the level as well as what sources of liquidity are changing. If the supply of cash and other readily available liquidity sources is dwindling, this needs to be identified and addressed before the institution runs into potential issues in the future. This type of measure should also take into account debt and borrowing capacities

Contingent liquidity.

Contingent liquidity incorporates emergency sources of liquidity, such as asset sales, wholesale borrowing, and other non-core funding sources.

See how improved liquidity analysis can improve profitability. Watch the webinar, "Liquidity Risk: A Key Prong in the Banking Supply Chain" 

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Asset-Based Liquidity Measures
Measuring liquidity to manage liquidity risk

Historically, liquidity has been measured with static, point-in-time measures, such as:

  • loan/deposit ratio
  • volatile funds ratio
  • borrowing/total assets ratio

Sometimes cash flow projections would be incorporated in liquidity measurement as well. The main issue with these historical measures is that they only show the state of liquidity today. They do not incorporate any projected cash flows, which are needed to alert management of any potential liquidity shortages.

A second issue these measures have is that they don’t incorporate off-balance sheet items, such as unfunded commitments. If an institution carries a large volume of commitments, it has an obligation to fund those commitments whenever the borrower draws on them, and that requires liquidity.

Today, more comprehensive measures of liquidity are used. As previously mentioned, asset-based measures are commonly used when evaluating liquidity in an institution. When calculating an asset-based measure, sources of liquidity are compared against uses of liquidity.

Sources typically include:

  • cash and HQLA assets
  • scheduled investment cash flows and maturities, and
  • scheduled loan cash flows and maturities

These sources fund the uses, such as:

  • loan commitments
  • maturing borrowings
  • non-maturity balances considered at-risk, and
  • potential draw-downs on lines of credit

To calculate an asset-based measure, simply multiply the sources by the uses, and if the result is 1 or greater (100% or more), there is adequate coverage within the institution from a regulatory perspective.

Basic Liquidity Ratio
Best liquidity risk practices for financial institutions

A common asset-based measure is the liquidity coverage ratio (LCR). This measure was introduced with Basel III and is required for banks with more than $250 billion in assets, or $10 billion in foreign assets, and the subsidiaries of these banks with at least $10 billion in assets. Financial institutions subject to BASEL III capital requirements must maintain unencumbered HQLA to meet 100 percent of the total projected net cash outflows stressed over a 30-day period.

Required or not, many institutions use the LCR as the standard measure of their liquidity. For sources, the LCR only considers cash and other HQLA and not any other anticipated cash flows. This is certainly a conservative measure. However, the issue it can cause for smaller community institutions is that to maintain an adequate LCR, the institution must hold on to more cash that can’t be invested into interest-earning assets. As a result, a best practice is for institutions not subject to the LCR to find other measures that include additional cash flows and other contingent sources that are bona fide available sources of liquidity. One such measure is described below.

Another standard asset-based metric used in conjunction with the LCR is the net stable funding ratio (NSFR), which gives a longer outlook on availability liquidity. The NSFR typically only applies to large banks but is a metric community banks should be aware of even if they are not required to calculate it.

This metric looks at the amount of available stable funding (ASF) institutions have over their required stable funding (RSF). The ASF includes the bank’s capital, preferred stock, and liabilities with maturities greater than one year. The components of the ASF are given a factor that represents the amount of the component’s value that will stay in the bank during a stress period. The RSF includes the weighted sum of the assets held and funded by the bank. Off-balance sheet exposures are included in the RSF metric as well. Institutions should maintain an NSFR of greater than 100% to be compliant.

A third metric, the Basic Liquidity Ratio (BLR), is similar to the LCR but has a crucial difference that improves upon the LCR. The BLR considers all sources of liquidity (including on-balance sheet), expected cash-flows (like loan payoffs), and contingent off-balance sheet sources.

Developed by Abrigo, the BLR can be summarized in three steps:

  • Step 1: Take stock of your available “liquid assets,” including cash flows from loans
  • Step 2: LESS short-term uses of liquidity, including off-balance-sheet activity such as firm commitments to originate and any potential draws on lines of credit
  • Step 3: ADD remaining available contingent liquidity sources within the bank’s policy limits

The BLR can be calculated in one of two ways:

  • (Total asset sources – total liability uses) / Total Assets – Set minimum level as policy
  • (Total asset sources / Total liability uses) where is >100% is excess, <100% is shortage, and a range can be set as a policy

 

Cash flow-based liquidity planning

To help manage the dynamic nature of liquidity and risks, financial institutions can take a cash flow-based approach to analyze projected changes in short-term liquidity based on changing circumstances. A liquidity gap report schedules sources and uses of funds out over various scenarios and subjects them to rate shocks or what-if scenarios. With this analysis, exposures to variables, such as source and use changes in different rate environments, allow the board and management to establish appropriate contingencies. This also enables institutions to stress test scenarios, such as missing deposit growth by 10%, the impact of slower or faster loan repayments, or other scenarios.

The advantage of this approach is that it’s a dynamic measure that incorporates changes in cash flows, and it can be stress-tested to allow institutions to identify any potential dangers in specific rate environments.

Regulatory agencies expect financial institutions to manage liquidity risk using processes and systems commensurate with the complexity, risk profile, and scope of operations. Understanding cash flow dynamics, regulatory expectations, broader liquidity considerations of the institution, and how to measure liquidity are the first steps for financial institutions in managing liquidity risk. And managing liquidity risk is essential to successful bank asset/liability management and successful credit union asset/liability management.

 

Read Part 5 of the ALM 101 Series: Non-Maturity Deposits


Read the series: "ALM 101: Introduction to Asset/Liability Management"

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About the Author

Zach Langley

Consultant, Advisory Sevices
As an Advisory Consultant on Abrigo’s Advisory Services Team, Zach Langley assists financial institutions in a number of ways, including transitioning to CECL, managing ALM outsource projects, and performing core deposit studies. He has also led Abrigo’s Paycheck Protection Program (PPP) Forgiveness outsourcing and capital planning/stress testing business lines. Zach

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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