ABA Banking Journal - April 2009 - (Page 16)
Community Banking Six action steps to take From those eight questions, Guglielmo moved to six steps bankers can take: 1. Determine how much liquidity you have. Guglielmo noted that a fundamental flaw of most traditional measures of liquidity is that they look backwards. Take the loan-to-deposit ratio—it’s a historical measure, not forward looking. In addition, many traditional liquidity measures don’t incorporate off-balance sheet sources of liquidity. Guglielmo said an effective measurement process should include: • Balance sheet liquidity—available cash and securities. This requires looking at liquid assets, such as unencumbered securities that aren’t already collateralizing liquidity sources such as municipal deposits or repurchase agreements. This analysis must also look at shortterm sources of liquidity that could disappear in a crisis, such as short-term deposits and Fed funds purchased. This evaluation must realistically consider how much of this liquidity would stick and how much would quickly depart. • “Just-in-time inventory”—sources such as Federal Home Loan Bank funding. This analysis must consider how much is available, how much is already being used, and how much will remain available in tougher circumstances. • A “strategic reserve”—sources tapped when necessary, such as reliable sources of brokered deposits. A fundamental needs, it will dictate what Guglielmo called the bank’s “real world” liquidity. This takes the bank’s planning away from looking solely at cash-on-hand and cash flow. The bank doesn’t want to have too much of its liquidity in cash, but must be able to count on realistic amounts of the other types. Furthermore, he warned, the outside sources must be based on established relationships, so the bank can realistically expect to go to those sources when needed. (He has more to say on this, further on.) 2. Estimate how much liquidity you need. Guglielmo said a bank must look forward, at its sources and uses of funds, to get a realistic handle on liquidity needs. He showed listeners a spreadsheet that contained both sources of cash and uses of it one month, two months, and further out. He noted that regulators nowadays like to see a six-month horizon in place. He said that at least a three-month horizon should be in place. Further, Guglielmo said that the horizons should be considered in three contexts besides “normality.” These are: “significant” liquidity crunch; “severe” liquidity crunch; and “doomsday,” to use his labels. “Examiners do want you to think about doomsday events,” warned Guglielmo. He asked bankers to consider how long their banks could maintain their activities local and national market elements. He went through many potential ratios to consider. The ones that apply to the bank’s circumstances should be gathered into a “scorecard” centralizing all of these factors and examining them in the three stress levels outlined above. “Get something on paper, and start to follow it, and learn from it,” said Guglielmo. Among his recommendations for internal factors to consider: basic surplus ratios; borrowings-to-assets; brokered CDs-to-assets; liquidity gap; interest-raterisk measures; capital ratios; deposit cash flows/decay; nonperforming loans/loans; chargeoffs/recoveries; growth rates; and loan-to-deposit ratio. Regarding the latter, a good point to keep an eye on is changes indicating heightened funding requirements. Also, look at deposit balances not connected to maturing deposits and at increasing usage of line of credit commitments. The speaker recommended many other such measurements. Among Guglielmo’s recommendations for external factors to build into the scorecard: credit events; economic indicators; industry trends in nonperforming loans; market rates/volatility; credit spreads; geopolitical events; and natural catastrophes. 4. Stress-test your funding needs and availability. Guglielmo noted that while most banks stress-test their balance sheet for interest- measure here is the maximum level authorized by the bank’s board, versus how much has been utilized already. • “Catastrophe insurance”—sources such as the Federal Reserve. This piece also includes secondary collateral sources, such as corporate securities, equity securities, and municipal securities that can be readily sold or offered as collateral. All of these considerations go into calculating the bank’s “basic surplus” of liquidity. Compared to the bank’s needs and potential if brokered CDs and other wholesale sources of funds went away. 3. Establish an early-warning system. No one ratio or approach is right for every bank, Guglielmo stressed. Banks must determine what measurements will serve as a warning to management and the board given each bank’s own balance sheet and risk profile. In addition, no bank is an island; management must take into account both rate risk, few stress-test for liquidity risk. Yet, he pointed out, “if your interestrate risk process results in notable changes in cash flow and valuation, your liquidity sources and uses will change, too.” Guglielmo covered key points to evaluate for liquidity stress. One is potential changes in collateral values. If the market-value of a security that could be used, or is being used, to secure outside liquidity, were to fall, then this would have to be addressed to maintain or 16 APRIL 2009/ABA BANKING JOURNAL Subscribe at www.ababj.com
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