Magazine article The RMA Journal


Magazine article The RMA Journal


Article excerpt

This series addresses liquidity management, concentrating on community banks with assets of less than $10 billion. Part 1 examined the regulatory environment. Part 2, which concludes the series, addresses liquidity from the perspective of balance sheet management.

LIQUIDITY MANAGEMENT REFERS to a bank's ability to fund increases in assets, usually the loan pipeline, and to meet obligations within the liability structure as they come due. The goal is to be able to meet these obligations without incurring unacceptable losses.

In day-to-day bank management, the primary reason for liquidity is to fund the loan pipeline. There are times when deposit outflows are an important consideration in liquidity management, but these instances are usually tied to a crisis situation, such as the failure of IndyMac in 2008. However, liquidity policies should spell out the guidelines for managing liquidity on a daily basis independent of a crisis.

Liquidity management is a primary responsibility of the bank's asset/liability committee (ALCO). The ALCO can usually roll over maturing deposits and other obligations, so the focus generally is on funding assets.

There are stages in the business cycle when it is easy to meet liquidity guidelines. and then there are stages when it is more difficult to do so. The dilemma facing the manager arises at the point when it becomes most difficult to manage daily liquidity--and that is the point in the business cycle when it is most important to follow the guidelines.

The following are common guidelines, each of which should be reported to the board on a monthly basis.

Primary Liquidity:

Cash and due Fed funds sold Overnight deposits Securities with maturities of less than one year

Primary Liquidity/Assets = 5% or greater

Secondary Liquidity:

Loans available for sale Securities with maturities longer than one year

Primary + Secondary Liquidity/

Assets = 10% or greater

Borrowing Availability:

Line of credit with Federal Home Loan Banks Other lines of credit

Total available lines of credit to support liquidity needs

Business Cycle and Liquidity Management

Table 1 lays out the most recent business cycle, starting with the top of the cycle in 2007 through the 2008-09 recession (the recession began in the fall of 2007 and ended in the third quarter of 2009). The table also includes the expansion that began in the third quarter of 2009 and is now continuing in the fourth quarter of 2016. It would also have been possible to track the 2001-to-2007 cycle or certain cycles in the 1980s or 1990s. All are slightly different, but the general principles still hold and are relevant to bank asset/liability management, including liquidity and credit management.

As the economy approached the top of the cycle in 2006-07, loan demand was very strong, loan-to-asset ratios were peaking, and liquidity was shrinking as funding was focused on the loan pipeline. Simultaneously, the yield curve was flattening as short-term rates were increasing more than long-term rates. Banks were running low on liquidity, and the cost of liquidity was rising.

In the fourth quarter of 2007, the entire scenario changed dramatically as the economy entered the recession. The loan pipeline slowed down, loan-to-asset ratios began to fall, liquidity increased, and short-term interest rates declined as the yield curve steepened. Banks were awash in liquidity and the yield on short-term securities was low.

Life isn't fair when your bank has no liquidity. The cost to purchase cash is expensive; conversely, when the bank is awash in cash the market interest rates are generally low. In the third quarter of 2009, the economy began to expand. Loan demand gradually increased and balance sheet liquidity declined. The expansion phase continues in 2016.

The current business cycle turned positive in the third quarter of 2009; at the time of this writing (fourth quarter of 2016) we are in the 30th quarter of expansion, albeit a relatively weak expansion historically. …

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