By Decker, Paul A.
The RMA Journal , Vol. 84, No. 7
Liquidity crisis? What liquidity crisis? Fortunately, community banks generally are experiencing few problems with liquidity at the moment. But this is exactly the time to take stock of how the bank would be able to perform in the event of such a crisis and to take the steps necessary to be prepared.
Until the mid-1980s, most community banks funded growth primarily through core deposits. These deposits were federally insured, stable, and relatively cheap. Rates paid on deposits did not fluctuate a great deal in relation to changes in general interest rates. Many seasoned bankers still fondly recall this era as the "good old days" in funding.
Funding growth through core deposits has become largely a thing of the past. The advent of nonbank competition and the rise of third-party funding mean that community banks now operate in a dynamic funding market, which requires the use of more sophisticated liquidity risk management practices.
Industry experts point to many different underlying causes for the demise of growth in deposits, such as the increased financial sophistication of the public, demographic shifts, the rise of nonbank competitors offering a whole wave of alternative investment products, new delivery systems such as the Internet, and competition from credit unions and insurance companies.
Here we have an interesting paradox. Community bankers have been complaining for years that their core deposit funding base has been eroding. How is this possible when call report data indicates that core deposits for the banking system have been increasing? A study of call report data indicates that while core deposits have been increasing in the banking system as a whole over the past decade, they have been flowing out of the community banks and into the regional and money center institutions, as shown in Figure 1.1
While the decline in core deposits as a means to support lending activity has had an adverse effect on liquidity, the unparalleled surge in loan demand in the last decade has had a far greater impact. This combination of increasing loan demand and decreasing core deposits has pushed benchmark ratios to historical highs. Perhaps the best indication of the impact this combination of market factors has had on bank liquidity is shown by the loan-to-deposit ratio, which has increased approximately 10% in the past decade, as shown in Figure 2.
To fund loan growth, community banks are increasingly turning to alternative funding sources, such as brokered deposits, Federal Home Loan Bank loans, and purchased fed funds. Unfortunately, third-party funding sources can be significantly more expensive. This places additional pressure on interest margins, increases volatility, heightens overall liquidity risk, and requires the adoption of a new set of liquidity management guidelines.
Of these third-party funding sources, FHLB borrowings are clearly the most important. At the end of 1992, few commercial banks had taken advantage of their newly acquired access to FHLB membership under FIR-REA. As a result, only 4.6% of commercial banks had any FHLB borrowings; these advances provided only 0.2% of commercial banks' funding.
By the first quarter of 2001, 45% of commercial banks had FHLB advances, which supplied 2.9% of the industry's funding. (2)
Clearly, the higher levels of third-party funding are rapidly forcing bankers to become masters at managing both sides of the balance sheet. Until the mid-1980s, the largely stable deposit base enabled community bankers to manage liquidity almost exclusively from the asset side of the balance sheet. Banks had large securities portfolios, which they relied upon to provide secondary liquidity and, during periods of high loan demand, would simply cut off lending until deposit growth caught up. Today, the availability of liability-side funding options and margin pressures have resulted in many banks placing less reliance on the securities portfolio as their secondary source of liquidity. …