Manage cash flow for the unexpected Bucket strategy helps control “optionality”

By Greg Garcia & Scott Martorana

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. On the liability side, a bank needs to understand its potential CD runoff and renewal as well as an assessment of core deposit outflows due to “hot money” leaving the bank. By understanding its level of runoff risk, an institution should be able to adjust deposit pricing to mitigate the impact of rising interest rates while minimizing deposit runoff that could impact cash flow.    

In order to avoid excessive risk, liquidity and investment policies should establish “buckets” or limits on various bond types and durations. Once a bucket gets filled, no more purchases go in that bucket. Limiting the balance of option bonds and staggering option terms within the portfolio will help avoid a “one-time” liquidity event that may occur at an inopportune time.

The portfolio should also be stress-tested under various interest rate scenarios to gain a better understanding of how optionality impacts cash flow and income.

Finally, when purchasing callable bonds at a premium, bankers should always know the “yield to call”—basically, the yield one can expect if the bond is called. For example, a 15-year final maturity callable bond with a 4.7% coupon purchased at 102% and callable anytime after one year will only yield 2.79% if called, after expensing the premium. â– 

Greg Garcia ( This e-mail address is being protected from spam bots, you need JavaScript enabled to view it ) and Scott Martorana ( This e-mail address is being protected from spam bots, you need JavaScript enabled to view it ) are managing directors of FinPro, Inc., a full-service consulting firm for financial institutions.