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.