Academic journal article ABA Banking Journal

Manage Cash Flow for the Unexpected: Bucket Strategy Helps Control "Optionality"

Academic journal article ABA Banking Journal

Manage Cash Flow for the Unexpected: Bucket Strategy Helps Control "Optionality"

Article excerpt

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There is great uncertainty surrounding the direction of interest rates. With the wide and sustained spread between long and short term rates, one can predict that spreads will narrow at some point. However, with so much economic uncertainty, how and when that spread narrows remains unknown. The banker's job is to manage the balance sheet to avoid placing excessive risk on the institution in ANY given interest rate environment. Profits that are made today can be gone tomorrow if risks are not managed appropriately.

Cash flow and liquidity are the lifeblood of a bank. Identifying cash flow over a given period can help bankers project (among other things) how much funding will be needed to cover loan obligations, how much that funding will cost, how much contingency funding may be available, and how much assets will yield. That data will help shape the strategic decisions pertaining to capital, lending, branching and staffing. It is imperative, therefore, to understand how changing rates will impact projected cash flow, and to utilize rate-risk models to accurately project that cash flow under varying scenarios.

There are several risks imbedded in a bank's balance sheet that can impact cash flow depending on movements in interest rates. For example, a bank with significant "optionality" on its balance sheet can see wide swings in cash flow as callable bonds or borrowings fall "in" or "out" of the money, resulting in an unanticipated cash surplus or deficit. Institutions with residential mortgages or mortgage-backed securities also run the risk of significant change in cash flow due to changing prepayment speeds. …

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