Navigating the Brave New World of Bank Liquidity

By Stackhouse, Julie L.; Vaughan, Mark D. | Regional Economist, July 2003 | Go to article overview

Navigating the Brave New World of Bank Liquidity


Stackhouse, Julie L., Vaughan, Mark D., Regional Economist


The third week of April 2003 offered a rare sight-an old-time bank run. The target was Abacus Federal Savings Bank, a thrift institution with assets of $282 million spread across operations in New York, New Jersey and Pennsylvania. Abacus Federal saw $30 million, or 13 percent, of deposits walk out the door in a four-day run on branches in New York City and Philadelphia. The run followed an announcement that Carol Lim, a branch manager, had been fired on suspicion of embezzlement.1 In the end, Abacus Federal-from all accounts safe and sound-weathered the run, though there were a few tense moments as the thrift faced the possibility that a short-term funding squeeze could escalate into a solvency problem.

Although runs have been rare since the 1930s, the balancing of sources and uses of funds is an important daily challenge for bankers. A large, sudden need for liquidity-as Abacus Federal faced in the extreme-can force an institution to sell choice assets at fire-sale prices or pay hefty interest charges in the short-term funding market. Scrambling for funds matters because it can seriously impair a bank's earnings and capital.

By some traditional balance-sheet measures, U.S. commercial banks face more liquidity risk now than 10 years ago.2 What accounts for recent trends in these liquidity measures? Do they point to deterioration in bank liquidity? Finally, what steps have supervisors taken to foster bank safety and soundness in this brave new world of bank liquidity?

A Liquidity Tempest?

Once upon a time, bankers and examiners leaned on the core-deposit-to-total-loan ratio to assess liquidity. The logic was simple: Core deposits-such as checking accounts, passbook savings accounts and small time deposits (under $100,000)-stay put, exhibiting little sensitivity to changes in market rates or bank condition. Other things equal, the higher a bank's stock of core deposits-or, put another way, the lower its loan-to-core-deposit ratio-the lower the liquidity risk.

Over the past 10 years, the aggregate loan-to-core-deposit ratio has "deteriorated" markedly. At year-end 1992, the ratio for U.S. banks stood at 92.9 percent, meaning that there was 92.9 cents in loans for every $1 in core deposits. By year-end 2002, the ratio was up to 121.2, meaning there was $1.21 in loans for every $1 in core deposits.3 Both cyclical and structural factors account for this trend. On the cyclical side, between 1992 and 1.999 annual loan growth at U.S. commercial banks averaged 7.9 percent, compared with average annual growth of 5.4 percent between 1984 and 1990. The pickup reflected the record length and strength of the 1990s economic expansion. On the structural side, between 1992 and 1999 core deposits grew at an average annual rate of 3.1 percent, down sharply from the average annual growth of 6.5 percent between 1984 and 1990. The slowdown reflected heightened consumer interest in non-deposit investment alternatives. For example, stock and bond mutual funds grew at an average annual rate of 10.7 percent between 1992 and 1999-even after adjusting for the run-up in the stock market. Over the same interval, money-market mutual funds grew at a 15.2 percent annual clip.

Or a Tempest in a Teapot?

Though stark, these balance-sheet trends really point to a "difference" in bank liquidity rather than a "deterioration." In the past 10 years, U.S. banks have tapped an impressive array of funding sources to operate with fewer core deposits. At the same time, maintaining safety and soundness with fewer core deposits requires a more sophisticated approach to measuring and managing liquidity. More sophistication means greater emphasis on overall systems for managing risk and less emphasis on static liquidity ratios drawn from balance sheet data.

For example, to plug the gap between loan and deposit growth, U.S. banks have turned in part to jumbo certificates of deposit-that is, time deposits with balances above the $100,000 deposit-insurance ceiling. …

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